To Profess or to Manage: That is the question

The weekend question from my investor, Mark, was certainly on target.  We used the occasion to describe our advice to Mark in the hope that other individual investors would benefit.  We had several interesting comments from our most astute readers, and also a new batch of web postings to worry Mark.

Perhaps we need to do more.

The Crux of the Issue

This is all about whether one wishes to be a professor or a fund manager.  Professors teach classes, do research, and attend conferences where there is often a lot of effort spent in the advocacy of small changes.  Investment managers figure out what works, often by spotting something unseen by others, and generate an investment edge for their clients.  Regular readers of "A Dash" know that I am a hands-on sort of guy who made a career change from professor, to investment researcher, to investment manager.

As a result of this career path, the perspective we take at "A Dash" is quite clear:  We show investors what is working.  We show how to navigate a path strewn with good-sounding debating points which have no predictive value.

That was the point of the conversation with Mark -- to show how we advise investors.

"Core" CPI versus the Headline

The criticisms of "core CPI" rained down upon us over the last few days.  Barry Ritholtz, an early critic of core CPI, further elaborated his viewpoint.   He cited quotations from Bill King, identified as another long-time critic of various inflation measures.  The very influential blog from David Gaffen at the WSJ online, cites several other critics of core inflation.  Doug Kass, who also writes a carefully reasoned and powerful column for theStreet.com, also reviews his long-standing objections to inflation measurement and cites (subscription required, but it might get to the free site soon) a variety of sources who agree with him.  They have also had this viewpoint for years.

We apologize for leaving anyone out, but at "A Dash" we focus on the strongest and most influential exponents for any position.

Why this dog does not hunt...

There is a process for influencing public policy formation.  Academics play an important role, discovering problems and suggesting solutions.  The measurement of inflation is no exception.  The issues were well understood thirty years ago, and the academic literature is active.

There are various problems with the criticisms advanced by bloggers and pundits:

• Their arguments are polemics, not scientific studies.  They play to the lowest common denominator of public understanding, since anyone can see that certain prices are rising.  The arguments ignore all of the difficult measurement questions -- substitution, quality improvements, falling prices in some categories, and how to separate living costs from investment and tax advantage in home ownership.
• Those advancing these arguments lack any economic credentials and often take pride in that fact.  If they really wanted to have an impact, they could write  papers, submit them for a journal or a conference, and participate in the debate.  Peer review settles many disagreements.
• Those criticizing the Fed's use of core inflation measures often seem to have a conflicted agenda.  They are either dedicated short-sellers or have a readership based upon that viewpoint.

The critics could have chosen to attend a conference like the one described here, by a real expert on the topic.  We know that readers will not actually follow the links and read the papers, but scroll down to the final conclusions.

None of the core measures worked that well.  Some picked up turning points better than others in low-inflation periods.  It is an ongoing debate.

Briefly put, the pundits and bloggers are acting like professors, but without doing the work to earn the right credentials, presenting their analysis for peer review, and influencing others who really understand the issues.  They instead are trying to influence people like my investor, Mark, who is just trying to get a good return for his retirement.

Our Perspective

The approach at "A Dash" is influenced by behaviorism in studying political institutions (with an additional strong component of positive political theory).  We try to understand why important decision makers act as they do.  When we write about their reasons, it does not mean that we necessarily agree with them.  It means that we understand their position.  We are trying to help the hard-working, intelligent investor to realize that government decisions are not some conspiracy.  The conclusion reached by the Fed is based upon the strongly held norms of the body, reflected in certain reasoning processes and conclusions.

Readers should also note that we have not done independent research on any inflation measures, so we have no opinion on which is best.  Our role is explaining why important decision makers act as they do.

This is a valuable perspective, unique for our readers.

How to Invest

The critical pundits seem to think that their observations on this topic will cause an epiphany at the Fed Open Market Committee.  There will be a sudden realization that inflation is out of control, and rates will be hiked, causing a recession.

This is not going to happen.

We would not be surprised to see further rate hikes, but it will be a result of continuing strong economic growth.

Please note the following:

• The Fed members and economists know everything that is written by the bloggers and pundits.  They knew it before the bloggers wrote it.  They have chosen inflation measurement methods for a reason.
• The Fed actually believes that CPI overstates inflation.  We know that seems incredible to those who read the barrage of commentary, but it is true.
• The Fed prefers the core PCE deflator as the best measure of inflation.
• The Fed believes that their past actions have already been working to bring core inflation into line.
• The Fed realizes that it cannot control energy pricing by raising interest rates.  The only thing they can control is inflation expectations.
• There will be some advance notice and publicity if the Fed viewpoint begins to change.

Finally -- the Sniff Test

At "A Dash" we have correctly had a bullish perspective based upon our free choice of various strong methods and our understanding of political institutions.  We are prepared to change this viewpoint if and when necessary, as we did for our investors in the 2000 era.

We recommend that readers of other sites employ a simple "sniff test."  If the writer objects to something like "owners' equivalent rent" as a measure, look to see whether the analysis is balanced.  This measure was adopted after many years of debate.  There was a reason.  If the writer does not describe that reason, he probably does not understand it, or he has a hidden agenda.

Ask also whether the writer has a clear path for explaining how the analysis of core CPI is going to lead to new public policy.  If that statement is missing, it is time to do your own homework.

Comments

[Bill aka NO DooDahs!]

Regardless of our opinions about the various price indices, the fact remains that they are data series that stretch back many years. The data, whether flawed or not, is at least relatively consistent in construction. This provides a huge number of test-able observations from which one could build a model to interpret how traders and investors react to changes in the series. The failure of some writers, who supposedly have a reputation for economic knowledge, to integrate this huge volume of data into a cohesive and accurate prediction of stock market movement, is quite amusing to me.

Even more amusing to me is the insistence of these same writers that the data is flawed, while ignoring the fact that their methods of integrating that data are at fault.

[F.]

One quick question: Just beause the Fed knows that they can't directly control oil prices which tend to introduce noise into inflation indicators, does that mean they are just going to sit on there hands and let inflation possibly increase beyond their liking?

I don't think so. Remember in '06 when the economists' consensus was for the Fed to stop hiking rates in May, but they deferred until August causing the summer crash? They stayed extra hawkish just to make sure they had squashed inflationary pressures regardless of their lack of control over energy prices.

Just a thought.

[oldprof]

Chris -

Actually, they prefer the core PCE deflator, which has different weightings from those used in the CPI. Their statements about the comfort zone and targets are all based upon changes in that measure. My main point is that those who want to understand what is happening for investment purposes should take them at their word. Fed communications have been pretty open on such matters.

In a sense, their reason does not matter. What I say about this is "educated speculation" from reading books about the Fed, the words of former governors, and studying political institutions for a long time.

Every institution has "norms" and new members learn those norms quickly. Fed Governors all talk tough about fighting inflation expectations -- even the "doves". They work hard to reach a consensus before actual votes.

Core measures have been used for over thirty years. The original introduction reflected the inability to cut OPEC prices by raising interest rates, although some cite the desire to help the Nixon re-election campaign. In recent years the "volatility explanation" has been popular.

So -- the Fed is not going to come out and say that this is the reason, but you can bet they are well aware of the reach and limitations of their policy actions.

A good question, and I wish I could give a more definitive answer.

Thanks,

Jeff

[oldprof]

Barry --

Yes, we have a few hundred very smart people who work on this all of the time. The are either clueless bozos who never buy gasoline, or they are looking at something different from the average consumer.

You had an intriguing post a while back that talked about the generally increasing quality of life. The idea was that it was something we were all entitled to. I'm probably stating it incorrectly, but that is how I remember it.

The BLS tries to measure these quality changes, and they have an impact, especially in things like technology and health insurance. I think that is part of the difference in the Fed view.

But the main point is that they have the power. You and I do not. Let's accept reality as part of our forecasts.

Thanks for your comment,

Jeff

[Chris]

So, do you think that the Fed prefers the core CPI as a measure of inflation because it captures the aspects of inflation that the Fed can influence? In other words, since Fed policy has little influence over food and energy prices, do they worry more about prices that they have some control over?

Am I understanding this correctly?

[Barry Ritholtz]

"The Fed actually believes that CPI overstates inflation. We know that seems incredible to those who read the barrage of commentary, but it is true."

What more can anyone say beyond that?