Inflation: CPI, Core Rate, Inflation ex-Inflation

by: Barry Ritholtz

I have been a critic of the official inflation rates for quite some time.

Long time readers know I do not believe that the BLS CPI data actually reflects the true price increases of the real world. Further, the Fed's focus on the core rate has significant repercussions for policy. Additionally, the debasement of the U.S. dollar means that U.S. have seen their purchasing power eroded just as surely as if inflation were even higher.

Recently, some have taken me to task for this. Brad DeLong chastises me, saying "Barry Ritholtz Does Not Seem to Understand the Purpose of "Core Inflation." Economics and... phrases the issue thusly: What is the core for?

These criticisms miss my main point. But that's probably my own fault, for not explaining the issue better. After you've posted on the same issue a few 100 times, you assume everyone has followed your line of thinking. Today's commentary will attempt to clarify that.

Let's start by framing the issue: Regarding inflation, these are the questions I want to explore:

1) What is the actual, real world, rate of inflation?

2) Why does the BLS model -- the "official" inflation rate -- vary so greatly from the real world? How significant is the spread between the two?

3) Why does the Fed Focus on the Core rate, and not the actual rate? What are the Fed policy repercussions of this?

4) What does this mean to Consumers? Investors? Savers?

(Our prior explorations of those questions are here).

Let's look at few new charts to see if they can shed any light on these issues. (For you "play along at home" types, here is the inflation data in Excel, via Bloomberg: CPI_vs. Core inflation.xls).

Any good economist will tell you that inflation is primarily a monetary phenomenon, so let's go to the relationship between Money Supply and Inflation, via Now & Futures:


chart courtesy of Now and Futures

Note the massive increase in M3 money supply. (Why the Fed decided to cancel the reportage of this key data point, we will leave to another discussion).

What has this increase in money supply meant for CPI? Let's look at the headline versus the core inflation data for the past 5 years:

chart courtesy of Michael J. Panzner

(Note: the plummeting inflation rate in the summer of 2006 was caused by a change in the widely followed Goldman Sachs Commodities Index -- now owned by S&P -- which temporarily sent Oil under $60).

Let's look at the spread between the two rates:


chart courtesy of Michael J. Panzner

Since late 2002, the core rate dramatically misrepresented actual inflation. This led to the Fed taking rates down too low, and leaving them there too long. The repercussions of this have been very significant, and are still being unwound today.

The bottom line is that ultra low rates, and big increases in money supply, sent the U.S. dollar to 15 year lows, raised the costs of all goods denominated in dollars, and lowered the standard of living for many people -- perhaps most -- living in the U.S.

This is why its is preferable for the BLS and the Fed to offer less spin on inflation, and to report actual, real world data -- not an artificial construct that consistently under-reports inflation.

I'll have more on this later . . .