Typically, there are two types of people in the inflation camp.
You have the people who follow the Consumer Price Index (CPI), which has come to represent inflation itself. But this metric has been so heavily manipulated over the years… it’s biased at best.
Then you have everyone else who has seen the cost of goods mostly rise, for whom deflation just seems a bad joke.
Personally, I don’t think I’m your typical “Joe Six-pack,” but the drop in commodity prices sure hasn’t helped my standard of living. And it’s not like I have a lot of extra cash lying around just because gas prices have fallen about 50% in the last couple years (I must not drive that much).
Wherever you stand on the matter, the fact remains that the Consumer Price Index is the most widely followed inflation tracker, and one that matters a great deal to the Fed.
So with the index coming in this morning flat at 0.0%, as expected… up 0.2% for the core prices (which excludes food and energy), as expected… and up 2% year-over-year, hitting the Fed’s target for inflation… it’s now more likely than ever the Fed will raise rates tomorrow.
Sure enough, the Bureau of Labor Statistics compiles the prices on a basket of goods to calculate price inflation, and a quick glance tells me that a few of my favorite things have gone up in price over the last few years.
Boneless chicken breast – up 13%.
Coffee – up 12%.
Bacon – up 18%.
Steak – up 32%.
And wine – up 66%!
On top of food prices, college tuition is going up – though I’m fortunate my youngest will graduate in 18 months! – and living in Tampa, FL I’ve seen housing prices move up. And don’t get me started on health care costs!
All this considered, you can’t help but wonder how inflation on the CPI is only up by 2%!
But like I said: the calculation has been manipulated over the years in a couple major ways.
CPI is a measure of changes in product costs over a period of time. The product “basket” can change when a product becomes too expensive and is substituted by a cheaper alternative. Like when you switch to hot dogs because steaks became too expensive.
Another way CPI is manipulated is through “hedonic” adjustments – a fancy word for pricing in quality improvements over price increases.
If you bought a 40” TV two years ago for $500, and today you buy the same size TV for $700, hedonically you might be paying less because of additional features (Picture-in-picture, HD, etc.).
These additional features, or improvements, add value and are deducted from the price. And magically, inflation is removed.
Finally, there’s the simple fact that the CPI weighs some products in the basket heavier than others.
For instance, food is weighted at about 14%, while energy is weighted at about 7.5%… never mind the fact it might be more or less for some people.
More interesting, however, is the cost of housing.
The CPI doesn’t measure how much you pay on your mortgage or determine a figure from the overall value of your home.
Instead, it calculates how much your housing cost would go up if you rented your house to yourself! Not only that, but this meaningless figure makes up about 25% of the calculation.
And another interesting note: there is no calculation – none – for an increase in sales prices for homes. Said another way: how people actually spend their money when they buy a house. Brilliant!
It’s not that the Fed wants a lot of inflation. As a consumer, our dollars buy less when prices go up. And as a bond investor, when inflation rises, the value of your bonds go down.
But no inflation or deflation tends to put the brakes on consumer spending, period. If you think prices are going up tomorrow, you’ll be more inclined to buy today. But if you think prices are going down, you’ll most likely wait.
And when people aren’t buying, the economy slows down and jobs are lost since companies aren’t making money.
So it’s clear why the Fed is obsessed with 2% inflation when it comes to interest rate policy. Any more and the economy might overheat… any less, and people might suspect they should wait until tomorrow to spend.
But with the CPI coming in today at expected levels, and the year-over-year change hitting the Fed’s target, they have the green light to hike.
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