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Volume 1 - September 13,
2004
Is Inflation Truly a
Threat?
By A. Gary
Shilling
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Welcome to the inaugural edition of
"Outside the Box." Each week, I read hundreds of articles,
reports, books, newsletters, etc. Each week, I and my staff
will bring you one essay which we think is worthy of your
time. The only requirement is that the article should make us
think, and perhaps challenge our assumptions. The subject
matter will be quite varied and will come from many sources.
There will be no requirement that I agree with the writer or
the thinking, just that it offer thoughtful analysis which
challenge our minds.
The first essay will come to us
from my good friend, Gary Shilling, who has been enlightening
me with his financial and economic commentary for many years.
This letter will certainly be "Outside the Box" for many of
you, as it will challenge some basic assumptions you have
about the inflation/deflation debate.
Many readers of
my weekly "Thoughts From the Frontline" write in to point out
that they believe the Consumer Price Index (CPI) reported by
the government understate the true inflation rate. Gary agrees
that the CPI might not reflect the true inflation rate, but
claims that the CPI is overstated rather than understated. The
argument and data that follows might not change your views,
but it will give you an alternate way to think about the CPI.
And if Gary is right, that means long term rates may be coming
down over time. It also has significant implications for Fed
policy and our own investment portfolios.
So lets get
ready to think "Outside the Box".
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Is Inflation Truly A
Threat?
By A. Gary Shilling |
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A revival in inflation in the U.S. has been a
major concern of investors. Until recently, the
spotlight was on employment, but the recent pickup in
payroll jobs, spotty as it may be, has convinced many
that more stable job increases are ahead. So inflation
worries have risen, along with the Consumer Price Index,
in recent months.
The Fed professes to not
be overly concerned, despite the congenital fear of
rising goods and services prices by central bankers
around the globe. Chairman Alan Greenspan weighed in on
the matter recently when he said the Fed's "general view
is that inflationary pressures are not likely to be a
serious concern in the period ahead." Of course, this
statement may have been in response to future markets,
which anticipate a rapid rise in the federal funds rate.
Still, on Sept. 8, he went further and said, "despite
the rise in oil prices through mid August, inflation,
and inflation expectations, has eased in recent
months."
Still, many Americans, including lots of
investors, think inflation is on the rise, and that the
Fed is behind the curve. In fact, many never believed
that consumer inflation rates were running close to 1%,
as reported recently, even after volatile food and
energy components are removed (Chart
1). They also didn't believe that producer prices
for finished goods were actually declining (Chart
2).
They also worry
that the recent leap in commodity prices (Chart
3) will soon feed through to finished goods producer
prices and then consumer prices. These worriers aren't
aware that there is so much value added between raw
materials and finished goods by labor, transportation,
packaging, capital equipment, etc. that a 1% rise in raw
materials prices only increases finished goods prices by
0.07% and less for consumer prices. A loaf of bread
contains only a few pennies worth of wheat. And this
effect is falling as goods contain less in materials and
more in intellectual content. A century ago, steel was a
major good; producing it takes lots of iron ore, coking
coal and limestone. Today, semiconductor chips are
important but require a little silicon and fine wire.
The rest of their value is brain power.
The widespread
fears of inflation are understandable. As we've
discussed many times in past reports, historically
inflation is a wartime phenomenon when government
spending is huge, while deflation reigns in peacetime.
Still, the nation suffered a uniquely long 60 years of
war, which started with rearmament in the late 1930s,
was followed by World War II, which promptly gave way to
the Cold War that was augmented by the War on Poverty.
So, most Americans have never experienced anything but
inflation, which they believe is the way God made the
world.
Furthermore, human nature puts more
emphasis on rising prices that may strain household
budgets than on falling costs. Maybe that's why we tend
to think that whenever we pay lower prices, it's the
result of our smart shopping and bargaining skills.
Airline ticket costs are falling due to competition from
discount airlines, but many people think they're
responsible for their cheaper tickets as they visit
airfare websites and pick the lowest fares (Chart
4). But higher prices are the work of greedy
corporations and other unassailable forces, probably the
devil himself. Who doesn't feel helpless, both
physically and financially, in the face of rising
medical costs (Chart
4)?
There's also a
strong tendency to remember price changes on frequently
purchased items, but can you recall what you paid for
your last water heater? You only replace it when there's
water on the floor—and you hope that's at 20 year or
longer intervals. And the rising prices of many
frequently purchased items, even though they are small
parts of household budgets, give many the impression
that inflation is rampant.
This year, Middle East
risks and other factors pushed up the price of crude oil
to nearly $50 per barrel (Chart
5) and gasoline at the pump followed with a
vengeance (Chart
6)—leaping 40% from December 2003 to their late May
peak of more than $2 per gallon—in view of the lack of
refining capacity in the U.S. The spike in this
frequently purchased item convinces consumers that
inflation is rampant even though gasoline only accounts
for 2.7% of consumer outlays.
Milk accounts for
even less, 0.2%, but the 10% plus jump in milk prices in
the past year (Chart
6) conveys the same impression. And since gasoline
and milk are necessities for most households, price
hikes are especially worrying and convince many that
inflation in general is spiraling upward even though
these two items account for a very small portion of
consumer outlays.
This concentration on small
purchases neglects the big price declines in big ticket,
infrequently purchased items that are often
discretionary and can be postponed if price increases
appear temporary—or delayed if further price drops are
expected. New and used vehicles (Chart
7) are in this category; outlays for autos and parts
account for 5.2% of consumer spending. Computers are
another example and, adjusted for the rise in computing
power, their cost to consumers has virtually collapsed
in the last 25 years while they have become more and
more important expenditures (Chart
8).
Consumers do tend
to neglect this important aspect of price indices—the
adjustments for quality improvements of the various
items. This is needed to account for the fact that
today's laptop computer has more computing power than
huge mainframe machines of 40 years ago. Even if a
washing machine costs the same as a decade ago, the
modern front-loading models are more convenient and use
less energy and water. These quality enhancements are
often forgotten even if people remember what they paid
10 years ago.
To be sure, the measurement of
quality improvements are ultimately judgment .calls by
the statisticians at the Bureau of Labor Statistics who
compute the producer and consumer price indices. If
additional computing power is needed just to run a
computer's operating system, is it a quality
improvement? Maybe not, but what if that system
facilitates more complex computing
tasks?
Despite the widespread belief that
inflation is much higher than reported, the evidence is
that the Consumer Price Index is overstated. A
congressional study found that the CPI was biased upward
in several areas. First, since the index has fixed
weights, it doesn't account for the tendency to buy more
of what's cheap and less of what's expensive. When apple
prices fall and orange prices rise, consumers buy more
apples and fewer oranges. In contrast, the deflator for
personal consumption in the GDP accounts is weighted by
the volume of purchases in the quarter in question. This
is an important reason why it records lower inflation
than the CPI (Chart
9).
Second, the group
of retail stores sampled monthly in the government
survey of selling prices changes slowly over time. As a
result, rapidly expanding discounters like Wal-Mart (Chart
10) are underreported while dying full-list price
mom-and-pop outlets are over weighted.
Also, quality
improvements are understated, meaning that prices are
recorded as higher than they would be with proper
adjustment. Computers are one example, and Chart
11 shows the vast difference between business
spending in nominal and real terms in the GDP
accounts.
The difference reflects quality
improvements, essentially more computer power per dollar
spent.
Another upward bias
in the CPI results from the fixed-weight base period,
currently 1982-1984. DVD players, wireless phones and
lots of other new tech items didn't exist 20 years ago,
but now account for significant portions of consumer
spending. And their prices have fallen dramatically,
meaning that the CPI is overstated since it doesn't
include them. Chart
8 shows this clearly in the case of
computers.
This study estimated that the annual
increase in the CPI was overstated by 1.1%. While some
subsequent adjustments reduced the CPI by 0.2% per year,
it still shows much more inflation than an unbiased
measure would report.
In fact, the U.S.
government has begun issuing chain-weighted CPI figures
along with the 1982-1984 official numbers. The chained
indices correct for the substitution and new products
problems and consistently show lower inflation rates,
both for the total CPI (Chart
12) and the core index that excludes food and energy
(Chart
13).
But inflationary
fears are so deeply embedded in most Americans that even
if they were able to set aside all of their convictions
that inflation is being vastly underestimated, they
would still believe that the Federal Reserve is
oblivious to the threat and is even promoting it with
rapid monetary expansion, especially since the beginning
of this year. The inflation hawks also point to areas
like housing. Until 1983, the owner-occupied housing
cost component of the CPI was based on the change in the
purchase prices of new and existing residences. This
approach was boosting the CPI considerably because in
the 1970s, house prices were leaping as Americans sought
havens from soaring inflation (Chart
14). Also, it recorded more CPI inflation than the
average family experienced by far. If, say, one in 20
bought a new or existing house in a given year, that
family felt a big cost increase, but the CPI spread it
over all 20. So a housing cost increase was implied for
the other 19 families when, in fact, they had none.
Finally, many were buying bigger, more expensive houses
than they really needed to get aboard the inflation
train. To them, a house was not just an abode, the cost
of which the CPI aims to measure, but also an investment
that it doesn't intend to include.
In 1983, the Bureau
of Labor Statistics shifted to the rental equivalence
approach. The exact measurement technique has changed
back and forth over the years, but basically estimates
the housing costs of primary residences as the rent on a
similar rental house or apartment. Interestingly, the
deflator for the personal consumption component of GDP,
which the Fed favors over the CPI, uses the same
approach (Chart
9).
In recent years, Americans have been
rushing into single-family houses in response to low
mortgage rates and very liberal lending terms, and also
due to the investment appeal of rapidly rising prices.
And they have been leaving rental apartments and houses
in the process, which has moderated the increases in
rentals. So, rentals and the owner-occupied rental
equivalent component of the CPI have both shown
declining inflation rates.
The inflation hawks
believe that this has artificially depressed the CPI.
Fair enough, and this is a big component. Owners'
equivalent rent of primary residence is 23.4% of the
CPI, almost four times the weight of actual rentals,
6.2%. Still, their recommendation that the CPI should
return to the house price approach could reintroduce the
problems discussed earlier. Clearly, the rapid rise in
house prices in recent years, which has far outstripped
its normal relation to the
CPI (Chart
15), reflects the shift in investment speculation
from stocks in the late 1990s to residential real
estate, and has nothing to do with basic
shelter.
In any event,
inflationary fears are so deeply embedded in most
Americans that even if they could set aside all their
convictions that the price indices are vastly
underestimating inflation, they would still believe that
the Fed is oblivious to the inflation threat and,
indeed, is promoting it with rapid monetary
expansion.
In particular, they note the
rapid growth in the money supply since the beginning of
this year. My problem with this, though, is that,
besides the traditional monetary measures, there are
numerous other measures of money, like credit cards,
which many consumers use to buy everything from
groceries to gasoline to clothing. In any event, the
money supply in the past year has grown less than
nominal GDP and has been far from
inflationary.
Furthermore, global excess capacity
should keep American business pricing power in check and
this, in turn, will maintain steady pressure on labor
costs. In addition, the Wal-Marts of the world are
another important factor in keeping inflation low as
cost-cutting and lower prices are made possible by
productivity enhancement.
In addition, consumer
spending will moderate considerably, especially since
the after tax income leaps due to tax cuts are history,
the big bulges in defense and homeland security spending
are probably over, and rising .interest rates will
depress housing and virtually eliminate cash out
refinancing. Also, high energy costs are, in effect, a
tax on consumer incomes. In this environment, business
spending on capital equipment, structures and
inventories is unlikely to be strong enough to sustain
rapid growth.
Some major financial institutions
that borrowed cheap short term money to speculate in
investment grade bonds, junk bonds, commodities,
currencies and emerging market stocks and bonds may
suffer severe difficulties as interest rates rise. Also,
the housing bubble may collapse with widespread price
declines that will have dire consequences for the 69% of
American households that own their abodes. But even
without these financial crises, the U.S. economy may
well enter a recession in 2005. And, the downturn could
be global if, as I expect, China suffers a hard landing
in her current attempt to cool her white hot
economy.
Indeed, the deflationary forces that
I've been addressing since 1998 and 1999 are still hard
at work. Besides global excess capacity and the
increasing importance of mass retailers like Wal-Mart,
robust productivity growth will be promoted by the
ongoing burst of semiconductors, computers,
telecommunications, the Internet, biotech and other new
tech. These and other factors will, I believe, lead to
an era of mild, 1% to 2% annual deflation rates—the good
deflation of new tech driven productivity increases and
excess supply, as was seen in the U.S. in the late 1800s
and 1920s, and not the bad deflation of deficient demand
experienced during the Great Depression and, more
recently, in Japan.
So I see the current rise in
inflation as being one more brief up tick within the
disinflationary trend of the past 23 years. And, so far,
the Federal Reserve apparently agrees. The central bank
will probably continue to raise its federal funds target
rate at a moderate pace, perhaps by one-quarter of a
point every six weeks at its policy meetings, through
the end of the year.
And then, as concerns about
inflation turn to renewed worries about deflation, the
Federal Reserve will switch from raising to cutting
interest rates.
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This letter may not change your
views on the CPI and inflation, but I hope it has helped you
think about the subject from an alternative
perspective.
One thing I have often pointed out to
readers that contact me is that their perception of inflation
hinges very much on the basket of goods they buy. Yes there
are some goods that everyone must buy, like gas and food, but
an older couple will probably spend much more on healthcare
and a young couple will probably spend much more on cell
phones, computers and furniture imported from china. So one
group feels inflation is running at 10-15% annually while the
other watches the price of their basket fall.
I would
like to thank Gary for allowing me to use his thoughts on the
CPI as the inaugural edition of the new letter. If you found
Gary's perspectives interesting, he offers an even more in
depth look at the current market trends and how they affect
the investment world in a monthly 20-40 page newsletter called
INSIGHT. To find out more about the letter and how to
subscribe simply go to http://www.agaryshilling.com/insightbox.html.
Your thinking "Outside The Box" analyst,
John F. Mauldin
johnmauldin@investorsinsight.com
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