Correcting perma bears on inflation

There is no shortage of pseudo intellectual arguments about inflation and how government manipulates inflation from the perma bears in press, TV and blogs. The crux of their argument is centered around core inflation which strips energy and food . The perma bears present the arguments in emotional terms not based on facts and logic, a good example of cognitive bias. A Dash of Insight has a very insightful lesson to these non economist on inflation.

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.

The Business Week also has a very good analysis about inflation in in this article:

Why are key price measures rising only modestly despite the energy runup? Credit the housing slump, Fed policy, and Wal-Mart

Buried on the 11th page of the government's June 15 inflation report is a stupefying statistic: From March through May, retail gasoline prices rose at an annual rate of 168.2%. The good news? Inflation pain didn't spread far beyond the pump.

According to the Bureau of Labor Statistics' widely anticipated report, core consumer prices—that is, excluding food and energy—rose just 0.1% in May. That was below most economists' expectations of a 0.2% increase. (The "headline" inflation rate, including food and energy, was 0.7%.)

Wall Street rallied on the news that core prices rose modestly despite the gasoline spike. The Dow Jones industrial average rose more than 85 points, or 0.63%, June 15 to 13,639. The Standard & Poor's 500-stock index and the Nasdaq market index also posted sizable gains.

Red Herring?

Motorists could be forgiven for thinking that prices are getting out of control as they see the digits whiz by at the corner gas station. The truth is, though, that overall inflation is surprisingly well under control. "There really has not been much pass-through," says Stephen Gallagher, chief U.S. economist for Société Générale.

The explanation for inflation's quiescence? First of all, that 168% rate of increase, while technically accurate, is something of a red herring produced by a short, sharp, and temporary runup. Compared to a year earlier, gasoline prices were up only 6%. Better yet, they have already started retreating. Pump prices have fallen 20 cents a gallon since hitting an all-time high of about $3.23 a gallon around Memorial Day weekend, according to the American Automobile Association (AAA) Daily Fuel Gauge Report.

The slump in housing has counteracted the rise in fuel prices, notes Mark Vitner, senior economist for Wachovia (WB). Owners' equivalent rent, which is a measure of housing costs, rose just 0.1% in May, matching the overall increase in core inflation.

Then there's global competition. Many U.S. companies can't raise prices to customers even if their own costs are going up, because if they do they'll lose market share to imports. Gallagher notes that the parts of the economy where inflation really is a problem tend to be ones that are relatively insulated from foreign competition, such as health care and education. That's one reason that most economists oppose import restrictions—they worry that consumers will bear the brunt of any resulting rise in prices.

Cheaper Drugs; No Rate Cut

Wal-Mart Stores (WMT) may have played a bigger than usual part in holding down May's inflation rate, speculates Vitner. The giant discounter has been expanding a program of selling certain generic prescription drugs for $4 a month, and other retailers have followed suit. Medical-care commodity prices were flat in May.

Credit the Federal Reserve, too, for caging the inflation beast. The Fed resisted calls to cut interest rates to keep the housing bust from dragging the economy down, notes Vitner. If the Fed had cut rates, inflation just might have heated up. Now, the economy seems to be regaining momentum after an anemic 0.6% rate of growth in the first quarter, even without interest rate cuts.

Says Vitner, "The best they can do is to not overreact when it appears the economy is being hit with a crisis. In the end, the so-called crises never seem to produce the damage that people fear."


Ritholtz said...

Actually, I said by focusing on the core the Fed risks their credibility.

See this article for an example:


Unknown said...

Inflation has been contained because of globalization and free trade downward pressures (especially from China). However, it is likely these democrats will place tariffs on Chinese goods in the near future. That will be quite an inflationary force.

nodoodahs said...

F., do you imagine that we have no tariffs on Chinese goods NOW?

Unknown said...

We are witnessing a policy shift right now as we speak: