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Is it misleading to rely on core inflation to determine the cost of living?

  • Yes (81%, 137 Votes)
  • No (19%, 32 Votes)

Total Voters: 169

Is it misleading to remove the cost of food and energy from the CPI measure of inflation? Do rising food and energy prices – commodities – alone portend a coming age of hyperinflation?

What the hawks are talking about

With gas prices soaring to record highs in California, the inflation hawks are in a tizzy. How can it be, they ask, that inflation is “stable” yet the true cost of living is higher than ever?

For hawks, the only conclusion that seems plausible is conspiracy — the Federal Reserve (the Fed) is cooking the books, relying on the artificial and misleading figure presented by the Bureau of Labor Statistics (BLS) in the Consumer Price Index (CPI).

Yes, in deciding monetary policy the Fed does indeed rely on CPI. However, it must rely on CPI. Without it, an accurate picture of price stability in the economy cannot be had.

The Fed gauges much of its monetary policy by tracking core inflation, as reported by the CPI. Core inflation is a measure of annual price growth based upon a basket of consumer goods and services, excluding the volatilities of food and energy — commodities.

Core consumer inflation is distinguished from the other measure of inflation that includes all items (food and energy plus all other goods and services exchanged on the market). This all-inclusive measure of inflation is known as headline inflation.

Herein lies the great point of contention. The hawks argue that recent spikes in food and energy prices not only portend a future of hyperinflation, but they screech that it is already upon us. With a popular catch phrase of the day, we are here to tell you, dear reader, that is a bunch of malarkey.

Shocking volatility 

The CPI excludes food and energy prices for good analytical reason when planning for the long-term. Both food and energy are, in the short run, extremely volatile, as are most commodities.

Further, both food and energy are much more sensitive to supply shocks than any other commodity. Their price instability aggravates their ability to help prognosticate future prices of anything.

The CPI excludes food and energy prices for good analytical reason.

For analysis, we look to the growth and vibrancy of our economy, which stems primarily from demandDemand is especially acute in the case of employers seeking workers and families hunting for housing. Food and energy, however, present a very different story.

Consider the recent surge in California gasoline prices. There is a resource restriction on refining caused by California’s “summer blend.” Thus dependent on California-based refineries, gas in California has topped six dollars a gallon in some regions. Also, and not good for Californians but part of the mix, several of our refineries have recently suffered from, shall we say, acts of god.

Thus, due to a fatal combination of supply restrictions, gas prices have ignited like never before.  Still, before considering inflation, they have not topped the highest price figure from 2008 for a gallon of the same gas – which of course fell significantly before this current surge.

The same occurs with food prices. Drought, floods, locusts and any number of acts of god or political imbroglios can affect the supply of food overnight. These interferences lead to dramatic price swings, though most are temporary. Thus, these fleeting price spikes are not permanent and do not immediately pass through to CPI inflation.

Speculation on food and energy commodities also results in much more volatile prices than other goods and services. Due to the sensitivity of food and energy prices to supply issues, Wall Street speculators frenetically trade futures and options on these goods. Speculators bet by the minute  on the calculated likelihood that prices will either rise or fall. Meanwhile, the demand for the commodities stays constant and the supply vacillates.

Along with riding the fickle winds of fate, speculators significantly add to the unreliability of food and energy prices.  Their bets, typically in momentum markets, hugely distort the slightest price fluctuations.

Speculators significantly add to the unreliability of food and energy prices.

Speculation (the same kind currently driving real estate) renders these commodities inappropriate for gauging real price stability in the economy. Price movement in commodities, either up or down, is not permanent as is the annual fluctuation in the CPI. CPI reflects the deliberate weakening of the dollar at the rate of around 2% annually. The interference of speculators, weather and production cannot be part of a permanent value change in the dollar, which is what we look to the CPI to gauge.

Related article:

San Francisco Federal Reserve Bank: What is core inflation?

One price the Fed can’t control

The Fed monitors inflation to gauge price stability in the economy. Using its inflation observations, it then sets monetary policy, usually by adjusting interest rates.

Calls to include food and energy in the primary measure of inflation come from uninformed or unreasonable demagogues, spewing twisted political rhetoric.

We are at zero-lower bound interest rates in the U.S. Interest rates cannot go any lower (the Fed has chosen not to “go negative” this time around!).

To combat zero-bounded rates, the Fed has tripled the monetary base over the last four years.  To this end, it has injected liquidity into the banking system via every expansionary measure it has at its disposal. If liquidity on the lending and money markets had any effect on commodity prices, wouldn’t we see the needle on gasoline prices respond to such aggressive expansionary measures?

The needle’s not moving much since the Fed has no control over food and energy prices, which move independent of lender liquidity.

Thus, no amount of monetary policy to enlarge or reduce the supply of money can create commodity price stability. Until the Fed gains total control over the weather and Ben Bernanke gets a chair on the OPEC cartel, including food and energy prices in the measure of inflation makes about as much sense as putting a screen door on a submarine hatch when at sea.

Related article:

San Francisco Federal Reserve Bank: Should monetary policy focus on “core” inflation?

CPI in the long run 

Over the long run food and energy prices average out to move at nearly the same rate as CPI. In other words: headline inflation converges to core.

In fact, headline inflation is shown to have converged to core inflation as of September 2012 by the recent inflation report published by the BLS. Both headline inflation and core inflation are currently at two percent.

Related article:

Bureau of Labor Statistics: September inflation report

How can this be when just one year prior (September 2011) the measure of inflation containing food and energy diverged from core by two percent, coming in at just over four percent? And why didn’t the Fed respond one year ago by aggressively reining-in their expansionary measures and putting a stop to surging headline inflation?

Thank goodness they saw through the rhetoric and didn’t, otherwise we would be in serious disinflationary (or even deflationary!) trouble right now.

The Fed did not react to commodity price inflation for good reason.

The Fed did not react to commodity price inflation for good reason. They understand that ups and downs in the price of food and energy, insofar as these commodities are necessary for sustaining the workforce, are ultimately integrated into the price of all other goods and services. Price spikes in food and energy are always temporary and eventually converge to the core. That is the evidence they have to work with.

At its core, the price of a commodity is constituted by:

  • the cost of labor and raw materials; and
  • profit.

Food and energy costs are necessarily tied-up with the cost of labor and raw materials. These commodities provide the means of subsistence for all workers as well as the means for extracting raw materials from the earth (chopping down trees takes a whole lot of gas). This is all averaged-out in the CPI over the long run and acts as a perfectly reasonable measure of inflation for the Fed to use to set monetary policy.

CPI, asset inflation and price appreciation

When considering real estate, its connection to CPI is via rents exclusively. CPI measures fluctuations in the cost of consumer goods and services. A home is an asset. Its land and improvements are not consumed (but deteriorate and become obsolete). Thus, one ought to (as does the CPI) consider rent as the cost of the consumable service that real estate provides — i.e. shelter. Ownership is the worth of the asset; rent is the value of its use.

Rents trend along with CPI. The universal standard of one-third of a worker’s gross income to pay rent means that rents follow incomes (historical evidence). Incomes increase along with inflation — when the price of services such as rent go up, so must wages. If not, consumers cannot maintain their standard of living (i.e. continue to make their rent year over year).  If income did not go up and rents did, eventually no one would be able to pay rent — the quintessential bubble.

The same is generally true for real estate ownership as well. In essence, real estate improvements are nothing more than labor and materials — both consumable goods tracked by CPI. Add the value of land and you have a property’s mean price.

As the price of goods and services (such as rent)fluctuate setting consumer inflation, so too does the mean price of real estate. This is asset price inflation.

Everything else in terms of an increase in price beyond inflation is appreciation. The greater the buyer demand for a particular plot of land in a specific geographic location, the greater that land appreciates. This phenomenon is driven primarily by varying population density and income levels. Asset price appreciation constitutes the peaks and troughs that swing above and below the mean price anchor: consumer inflation.

Related article:

Calculating owner-occupied housing in CPI: a high-stakes and contentious quandary

Now imagine if all this pricing was considered not in terms of core inflation, but with both food and energy prices included in the inflation index. Computing rents, calculating cost of living, determining ability to pay, setting interest rates and wages, and so on and on, would all be on a schizoid funhouse ride of daily bubbles and busts — simply untenable.

Shooting down the hawks

One can clearly see the practical and mathematical reasons why core inflation is the accurate and thus preferred measure of inflation.

But the inflation hawks are not so concerned with mathematics or reason. Rather, they operate on irrational fear.

At the heart of the hawks’ squawking about core inflation lays the core belief money ought to have a fundamental and tangible standard of value — i.e. gold. Since national and global economies use fiat money without a tangible value anchor, the fear is that a so-called dollar bubble will occur, leading to hyperinflation.

The reality is that fiat money relies on a social agreement to use it as a store of value. Only a massive world-wide US dollar mutiny would prevent the process of monetary circulation from continuing in perpetuity. In other words, fiat money works as long as we agree that it ought to by continuing to use it as a medium of exchange.

With the Fed operating appropriately as it has overall from its inception, no dollar bubbles will occur — it’s all just hype.  Arguably the Fed was lax in the 1970s, and in the early 2000s driven by their response to 9/11.

Related article:

New York Times: Things that aren’t bubbles

So, the savvy buyer and their agent will keep a close eye on core inflation. At the end of the economic day, single-family residence (SFR) ownership has repeatedly proven itself as a simple hedge against consumer inflation, after food and energy costs are extracted from the equation.

Just do not pay a price distorted from the historical mean price. That includes an annual adjustment for consumer inflation tracked by the CPI.

Related articles:

Hyperinflation — yesterday’s news

The equilibrium trendline: the mean price anchor