The "Fuzzy" CPI
Inflation is Sighted
Inflation has been defined as too many dollars chasing too few goods. At the current growth rate of the U.S. money supply, we would expect CPI numbers to be going wild, but they are being reported as tame.
Since 1972, the M3 which is the broadest measure of the U.S. money supply, has significantly increased. M3 has been increasing around 8.1% annually, while the CPI has an annual growth rate of about 5.1%.
It has only been during the Clinton era that the CPI and M3 have dramatically parted ways. While the M3 has continued to climb substantially, the growth rate of the CPI moderated until very recently.
More interesting is the fact that, the three-month annualized growth rate of U.S. monetary supply at the end of 1999 was marked by an astonishing increase of 27%, almost triple the highest rates in the past fifty years. An enormous inflation spike would very likely follow money supply growth of this magnitude.
It is hard to believe that the money supply could increase so much, yet inflation remain low.
Another factor that increases inflation is higher oil prices. Higher oil prices raise the cost of doing business, which can lead to higher consumer prices. Also, higher oil prices raise the cost of day to day living as consumers pay more to fill up their SUVs, heat their homes and cook their dinner. With the price of oil erupting, one would expect that the CPI would also be gushing, but it has been capped.
The price of crude oil has been steadily increasing from $10 a barrel in 1998 to over $30 a barrel today. However, the BLS (Bureau of Labor Statistics) reported that the "petroleum-based energy index declined 5.5%" during August 2000, when crude oil actually rose an amazing 19.3%, the ninth largest spike in crude oil prices since 1970.
According to Adam Hamilton, contrarian analyst and publisher of Zeal Intelligence, not a single month exists in history where crude oil leapt up greater than 5% in a single month and the CPI actually declined! Until this virtual reality known as August 2000, that is.
Oil prices have tripled, increasing producers' costs and sending gas and home heating prices into orbit. Yet despite these increases, and the enormous role played by oil and its by-products in the economy, the BLS has continued to report the CPI to be nearly flat.
The Consumer Price Index
The Bureau of Labor Statistics defines the Consumer Price Index as the "measure of the average change in prices over time in a fixed market basket of goods and services bought by consumers for day-to-day living."
A "Brief Explanation of the CPI," in the October CPI report, states:
"The CPI is based on prices of food, clothing, shelter, fuels, transportation fares, charges for doctors' and dentists' services, drugs, and other goods and services that people buy for day-to-day living."
The BLS also defines the term inflation to be "a process of continuously rising prices, or equivalently, of a continuously falling value of money...the CPI is generally the best measure of inflation."
The BLS has been working for the last few years to portray the U.S. economy as strong and inflation free. The government has manipulated the CPI inflation numbers in several ways.
The first way the government has manipulated the CPI results is by discounting the "volatile food and energy sectors" of the CPI report.
A footnote toward the end of the CPI report states:
"Effective with the calculation of the seasonal factors for 1990, the Bureau of Labor Statistics has used an enhanced seasonal adjustment procedure called Intervention Analysis Seasonal Adjustment for some CPI series."
Basically, what this statement means is that "extreme values and/or sharp movements which might distort the seasonal pattern are estimated and removed from the data prior to calculation of seasonal factors." These so-called extreme values included "the fuel oil and the motor fuels indexes," which are, according to the BLS, characterized by "extreme price volatility."
By removing seasonal factors and food and energy prices from the CPI, the government touts this "core rate" CPI as a better indicator of inflation. The core rate CPI is not a better indicator of inflation, it just paints a better picture for the government to exclaim that inflation is not rising and the economy is healthy.
But the average consumer is not fooled by this attempted cover-up. Consumers have to buy food, drive to work, and heat their homes. They know that food and energy prices can't be taken out of the equation, because they still have to pay their food and energy bills each month.
A second method that the government is using to thwart fears of rising inflation caused by higher oil prices is the theory of the "New Economy." According to those proponents of the new economy theory, crude oil no longer plays a major role in the day-to-day living of the average consumer. The theory asserts the Internet and computers are restructuring the economy to the point that crude oil is no longer considered to be important in the economy.
Although it is true that the economy is changing radically, oil is still a necessity to provide electrical power for the computers on the Web, to heat the warehouses, to fuel the delivery planes, trains, and trucks, and to provide day-to-day transportation for the average consumer. To simply eliminate the figures because they are considered less important does nothing but provide inaccurate inflation information that is crucial in determining the state of the economy.
The final technique used by the government to massage the CPI numbers into favorable results is to apply a little "fuzzy math." If you don't like the results, change the formula until you get results you like.
Since the beginning of the Clinton era in the early 1990s, the government has made gradual adjustments to the CPI formula in order to create a lower inflation figure. The BLS is now using what they call the "geometric mean," which measures the price of a group of products by weighting the price of each product, instead of the previously used "arithmetic mean," in which you simply added up all the prices of the items.
John Williams, of the Shadow Bureau of Government Statistics, says this new method "means anything that goes up in price automatically gets a lower weighting in the (inflation) calculation. Anything that goes down in price gets a higher weighting."
According to the BLS, the justification for changing the formula for calculating the CPI is that as prices rise, consumers switch from higher priced products to alternatives that are more reasonably priced. Thus, the CPI formula should reflect this by weighting higher priced products that have less demand and place more weight to those cheaper products that have higher demand. It works on paper, but not in the real world.
Many consumers prefer to stay with specific products, "brand loyalty," or there may be no substitute products, like gasoline. Oil prices have continued to soar, but their impact is understated in the new CPI formula. Consumers are expected to make unreasonable substitutions, for most average households, like busing, biking or walking to work. These are the alternatives the average consumer must face in order for the government to justify a lower inflation number by a simple formula change.
In a recent article, NewsMax.com revised Mark Twain's remark that "Statistics don't lie, people do," with "governments do too."
During the Clinton administration, the BLS has reported the CPI to be relatively flat. Even with the recent jump in crude oil prices, the CPI has continued to remain dormant, even decreasing at times.
The reliability of the CPI, as an accurate indicator of inflation, is something that has recently come into question by many economic analysts. Federal Reserve Chairman Alan Greenspan has publicly stated that he'd no longer take the CPI into consideration.
What is concerning to most investors, and more importantly Chairman Greenspan, is the fact that the core inflation rate is rising. The core CPI recently rose 0.3%, without taking into consideration the effects of the spillover from increasing energy prices. The overall impact of an understated CPI figure will eventually trickle down to the American consumer.
Common sense indicates that a dramatic rise in oil prices, as we have seen, leads to large increases in the CPI, but not in the United States. In Europe, governments and the European Union have reported a sudden rise in inflation due to oil price increases, but the U.S. federal government claims oil prices have little effect on inflation. What is reality?
With the bull market in stocks stumbling to a halt, the basis for that bull market, the false belief of a low inflation economy, could easily come crashing down on stocks once the true inflation picture is realized. The strong productivity growth rates in the economy that investors have enjoyed will not be able to hold off inflation indefinitely. With oil prices continuing to rise, instability in the stock market, and no end in sight for the crisis in the Middle East, the addition of a delayed impact of an understated CPI may ultimately lead to a recession accompanied by high inflation: stagflation.
December 15, 2000
Blanchard Economic Research