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business newsWhat the Fed Ignores When It Denies Inflation
By
Lee Adler
Mar 17, 2011 1:00 pm
The Fed likes to strip out the prices of things that are rising in price when it measures inflation, focusing on the "core rate" rather than the "headline rate."
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The Fed likes to strip out the prices of things that are rising in price when it measures inflation, focusing on the “core rate” rather than the “headline rate.” The core rate excludes food and energy; in other words, the core rate excludes “necessities.” That rate rose by just 0.2% in February, so no problem, right? For Head of New York Fed William Dudley and friends, maybe, but not for those of us in the real world who have to buy things like gas and food. We’re feeling that 0.5% jump in the headline rate, and then some.
I thought I’d take a look at some of the things that real people have to buy to survive -- like food and energy. These are the necessities that the Fed likes to ignore when it is explaining to everyone how there’s no inflation. Energy prices were up by a stunning 1.6% in February. That’s on top of 2.4% in January, and 2.8% in December. In fact, since the Fed started QE2 in November, the energy component of the CPI is up by 8.3%. If you’re annualizing, that comes out to a mere 27%. But Ben Bernanke dismisses that because “it’s transitory." It’s true that energy prices have dropped just a bit here in March, but “it’s transitory.”
What about food? Food prices were up 0.4% in February according to the BLS. January saw a gain of 0.9% and December just 0.1%. Since the Fed started QE2, food prices are up 1.1%, or just over 4% annualized. As a grocery shopper that seems low to me. Not only are prices rising, but package sizes are shrinking. But I won’t quibble with the BLS figure. Let’s just assume that it’s true.
Since the Fed likes to pretend that the only prices that matter are the ones that aren’t going up, I thought that it would be nice to construct an anti-core, anti-Fed CPI, stripping out the prices of the things that are going down, and that seem to have an inordinate amount of weight in the core CPI. And what might that be? You guessed it -- housing, aka shelter.
So here’s my version of the anti-core, anti-Fed CPI -- the CPI of everything except shelter. Using the BLS data, anti-Fed anti-Core was up 0.6% in February, 0.6% in January, and 0.2% in December. It was unchanged in November. Since the Fed started QE2 the rate was up 1.4%, or just over 4% annualized.
But does that tell the whole story? The Fed actually had the audacity to reveal in its January FOMC minutes that it felt that it was difficult to understand the transmission mechanisms of inflation in real time. That’s definitely true if you have your eyes closed, your hands over your ears, and you’re holding your breath in denial until you turn blue. That’s the Fed’s usual modus operandi.
It's actually not so hard to see or understand inflation in real time. In fact, MIT is actually doing it every day. MIT publishes a daily real-time on-line inflation index called the Billion Prices Project. It measures the prices of 550,000 items (OK, so it’s not a billion) in the US daily from online prices. Its index was up 0.57% in February, pretty close to what the CPI is telling us the headline rate was. And here’s the kicker: Through March 16 the index is up over 0.3%, so it continues to run at a 0.6% monthly pace. That annualizes to over 7%. Since the Fed began QE2, this index has risen by 1.77%, which also annualizes to over 7%.
MIT Billion Prices Project Inflation Chart
The Fed ignores inflation because it refuses to accept responsibility for causing it. This denial means that something’s gotta give. If the Fed continues QE2 through June, this inflation will continue, and may even accelerate. Furthermore, it will have residual momentum. It may take on a life of its own even when and if the Fed does stop printing.
In the meantime, according to tax collections and other data that I track, the economy is stalling. That conclusion is supported by today’s weak industrial production data. So the Fed is now in a catch-22. If it stops the money printing, yes inflation may subsequently slow, but the illusion of economic growth will also be laid bare. If it doesn’t stop the money printing, inflation will continue to rocket upward, and the economy will be forced to contract due to the inability of customers to bear increasing costs, not to mention supply chain disruptions. So pick your poison.
I’m not a big believer in valuation analysis. When you enter a Las Vegas casino, the only value that matters is the price you pay for the chips. It’s no different with stock prices. But, for those of you who do follow this valuation analysis, if inflation really is 7% (and it is), then Treasuries yielding 3.5% sure are no bargain. In fact they are grossly overvalued. If you got 'em, this would be a good argument for selling them. What should yields be? The theoreticians might tell you that a 3% real yield would be about right. That would put the 10-year Treasury yield somewhere around 10% when you add inflation. Ouch!
As for stock prices, the Fed yield model would suggest that on an earnings yield basis stocks should yield about what the 10-year Treasury should yield, or around 10%. That translates to a PE of 10. The S&P 500 earnings for 2010 was $83.66 according to Bloomberg. Corporate tax collections are falling, indicating that corporate profits are falling. Chances are that 2011 earnings will be lower than 2010. I’ll just guess that they’ll be down by 20%, but let’s say they’re not, and they stay level. That would still argue for an S&P of around 840.
Technical, cyclical, and liquidity analysts have been screaming to get out of the market in recent weeks. Even if you believe that technical analysis is mumbo jumbo, but you do believe that maybe this 7% inflation figure is real, then you have a rationale for believing that it’s time to get out of both stocks and bonds. However, if you don’t believe that inflation is a problem, I won’t tell you where to go.
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