Worries about Inflation: A Chat with Mark

Another month of data shows inflation to be contained while many forecasts for economic growth show a brisk rebound.  The stock market made an appropriate response, so a pleasant weekend was in store.

Then the phone rang.  It was Mark, a very intelligent investor who does a lot of reading from many sources.  Mark was worried about  inflation.

The Conversation

Mark:  I just read the real truth about  those inflation numbers.  First the government fooled us by rounding down the increase in the core rate.  What a joke!  The market did not see that, so it rallied.

Jeff:  We have talked about this before. Do you think that because you divided the price index for one month by that of another, you have information that is better than the rest of the market?

M:  I read it on a web site.  More than one, in fact!

J:  And you think that all of the big money traders did not do the calculation for themselves.  Or read the same web sites?

M:  Hmm.  Well maybe they were off in the Hamptons and the "B" team was on duty

J:  Or maybe the collective wisdom of the market was that a 1.5% annualized rate of increase was pretty good -- better than expected?  Maybe it means the Fed is doing something right.

M:  Why do you say that?  Everyone I read tells me how stupid the Fed is.  They created various bubbles and have basically caused the terrible conditions we have now.

J:  Would you be referring to corporate profits -- at a record with great increases?  Or employment?  At record lows?  Remember what I told you about being a contrarian?  It is easy now.  You only need to think that the Fed is doing a reasonable job.  That seems to put you in the minority.

M:  But they do not understand inflation.  They use some silly core rate with a bunch of adjustments.  I know that my costs are increasing much faster.

J:  As we have before, Mark, we come back to measuring the cost of living.  Here is the simple version.  At any given time, the price of some items is going up and the price of others is going down.  Any fair method has to take this into account.  It is also possible to substitute things that get cheaper for things that are more expensive.  Finally, there are a lot of changes in quality.

M:  Yawn.....

J:   I understand.  When I try to write about measuring inflation, absolutely no one agrees with me.  Everyone -- all non-economists who have NEVER had the job of actually trying to do this -- believe that they know best.  They know better than economists who make a career of this.  They know better than Congressional Commissions tasked with finding the best measure.  I understand.  There are some arguments where a writer can appeal to the lowest common denominator and readers will buy it.

But you see -- that is an investment opportunity.  The Fed is not going to change its view about inflation measures because some bloggers and TV pundits do not understand what they are doing.

M:  Barry Ritholtz says that the Fed will lose credibility.

J:  The Fed is not worried about their credibility on inflation measures.  They are worried about their credibility on containing inflation expectations.  That is why we see so many jawboning speeches.

M:  I know that you are wrong, because I am watching the Big Mac Index and the Martini Index.  Food and energy prices are higher, also.  This is real inflation, not the bogus core rate.

J:  Part of the reason that food is higher is that our energy policy has driven up corn prices.  I wrote about this months ago.  But here is a good test for you.  We can make a little bet.

M:  OK, Jeff, you know I am always up for that.

J:  Here is the bet.  There are certain websites that always find the worst in the data for any week.  This week the core rate was low and the energy prices were high.  There will be a time when the core rates will be high, but the monthly change will be lower.  I will bet you that the websites you are citing will not point that out for you.  Our customary stakes.

M:  We need to agree on the sites.

J:  Of course.

Here is a bonus --

Let us assume for a minute that energy prices were rising, basically because of OPEC control.  What would be an appropriate policy response?

Those writing at various perma-bear websites seem to think that the Fed should hike interest rates.  These guys need to review their Econ notes.  Tightening rates to kill demand is not a good weapon against cartel pricing.

While the Fed does not discuss it much, the members of the Open Market Committee and their 350+ economists are smarter and more knowledgeable than the bloggers.  While they want to control inflation expectations, they are not going to crush the economy in a pointless move against energy prices.

The next time someone wants to give you a lesson about "core inflation" you should think  about that concept.

Comments

[oldprof]

Thanks for the pointers and comments from all. I think I need to do a follow-up post on this one, since I did not seem to get the point across on the first pass.

Your feedback will help me do better, perhaps.

Jeff

[oldprof]

David -
Thanks for your comments - always factual and helpful. As you know, I'm happy to have people disagree, especially those with something to say.

I am a bit surprised though, since I do not particularly endorse the Fed's use of core inflation. I am a realist, though, so I believe we should keep an eye on their chosen measure.

I am curious. How do you think I should advise my client, Mark? What would you tell one of your clients who was going to sell stocks because of this inflation measure?

Thanks,

Jeff

[Bill aka NO DooDahs!]

Therox, why don't you just direct them to the Capital Stool?

[theroxylandr]

Another post about inflation:

http://theroxylandr.wordpress.com/2007/06/15/inflation-is-in-danger/

[muckdog]

Aren't we all guilty of rounding to give us the best outcome? We round our height up. We round our weight down. So are we shocked to see the inflation numbers rounded down?

The CPI is a very large basket of stuff. We're all quick to jump on the things that went up in price, but nobody ever mentions the things that went down in price. I listed a few the other day.

But there is one sad tale to tell:

In Germany, farmers are ripping out barley crops and planting corn for alternative energy. Think about it. Here it comes... BEER prices are skyrocketing!

"D'oh!"

There is no hedonistic adjustment to be made.

[RB]

The Fed studies indicate that energy prices have mattered less for the core than inflation expectations
http://www.nasdaq.com/econoday/reports/US/EN/New_York/resource_shorttake/year/2007/weekly/13/index.html

but the Fed is starting to recognize the importance of energy prices in maintaining inflation expectations
http://macroblog.typepad.com/macroblog/inflation/index.html

[Barry Ritholtz]

Food and energy are dropped from the core rate because they are volatile from month to month and will cause understatements and overstatements in inflation estimates based on month to month price changes.

However, I understand wanting to remove an unusual spike (I.E., Post-Katrina gas surge).

But 5 years ago, Oil was $18; Its now $68; Milk was $2 a gallon; now, its now heading to $5. Medical costs have gone up relentlessly between 10-15% / yr.

If you want to remove the monthly volatility, you can drop the outliers (like the Cleveland Fed does), or use a moving average, or look at the year-over-year numbers.

All three methods reveal that (non-volatile) inflation is MUCH higher than the reported core.

There's data smoothing, and then there's inflation ex-inflation. The core rate is looking more and more like an exercise in hiding the true state of price stability.

[David Merkel]

Jeff, I agree with half of your points here, but wouldn't it be better to drop "core inflation" which was only adopted because of the volatility of food and energy prices, and use a better statistical technique to reduce volatility (one that does not consistently throw away a set of data)?

I prefer the Cleveland Fed's median CPI calculation. When the distribution is unknown, the median is a more robust estimator of central tendency than the mean (and less volatile also). Or the Dallas Fed with their "trimmed mean." That is also a better measure of central tendency when the distribution is unknown.

It's not just the last few years. By excluding food and energy, core inflation has been lower than inflation for the last 20 years. We need to move to inflation measures that include all data, while smoothing out aberrations. The median CPI does this. Core CPI does not.