IronStats

Is the CPI (Consumer Price Index) A Valid Metric For Inflation?

Is the CPI (Consumer Price Index) A Valid Metric For Inflation?

The Consumer Price Index (CPI) is one of the most oft used techniques for measuring inflation the world over. Specific countries scrutinize different sets of data, but all employ a similar method. In the US, there has been contention surrounding the CPI for many years now. Initially, it was calculated by contrasting a market basket of goods from two periods – effectively operating as a cost of goods index (COGI). Yet, under the auspices of the US Congress, the CPI eventually developed into a cost of living index (COLI). In addition, as time passed methodological changes occurred which often resulted in a lower CPI. In this article, experts weigh in and provide compelling insight into whether the Consumer Price Index is a valid metric for inflation.

A Better Measure Would Be “Chained CPI”

“The Consumer Price Index (CPI) has long served as the foundational inflation measure for economic activity. In fact, it underpins the health of an economy because a stable CPI measure indicates the opportunity for economic prosperity. Absent predictable CPI readings, consumers will not have an accurate signal about price expectations and may change their behavior in detriment to the economy as a whole.

One major limitation to the current CPI measure is its inability to incorporate decisions consumers might actually make when evaluating a fixed basket of goods. For example, when a price increases for one consumer product included in the selection of goods used to measure CPI, many consumers would choose to switch to a substitute. CPI doesn’t account for this reality. Instead, CPI assumes the consumer would simply pay more for the same product. Reality usually shows a different response in the form of choosing a substitute product.

Instead, a better measure which accounts for this substitution effect would be “chained CPI.” This more closely resembles the substitution decisions consumers would make in response to rising prices of certain items as opposed to simply paying more for the same good. This metric will capture the switching dynamic.”

Riley Adams, CPA, Youngandinvested.com

Not An Exact Reflection, But Gives A Good Feel For It

“The CPI isn’t an exact reflection of the inflation rate, but it gives us a good feel for it. For the consumer, it shows them the increase in the price of the most common items that people buy, so if this is what they want to know when it is perfect.

However, for anyone interested in a deeper look at the current inflation rate there are other factors to take into account. For example, the CPI is based on a fixed basket of goods rather than taking into account every single product available. So, it really comes down to the reason for wanting to understand this subject.”

Phillip Konchar, Head Tutor, My Trading Skills

CPI Is Likely The Best Measure

“The CPI is one of a few common economic indicators that attempts to measure the magnitude of price changes (inflation) in the economy. The CPI, as the name indicates focuses on the price changes experienced by consumers. There are better indicators if one is looking at price changes for producers
(Purchaser Price Index – PPI), imports and exports (Import/Export Price Indexes – MXP), or employment costs (Employment Cost Index – ECI).

One drawback of the CPI is the time lag associated with the basket of goods included within the CPI. The basket of goods is determined by surveys the Bureau of Labor Statistics conducts to understand what products consumers are purchasing. There is generally a lag of about three years from the survey to when the basket of goods used in the Index is updated. This can be meaningful as the items consumers are purchasing can change quickly, particularly with rapid change in technology or substituting one good for another.

One other consideration is that the CPI can be volatile as it includes volatile products such as the price of energy (gasoline and natural gas prices can be quite volatile) and food. The Federal Reserve prefers to use a core inflation metric that excludes these volatile goods. The core inflation index the Federal Reserve prefers is the Personal Consumption Expenditures Price Index published by the Bureau of Economic Analysis.

Overall, the CPI is likely the best measure of the change in prices that consumers actually experience within an economy.”

John Linton, Managing Member and Portfolio Manager, Elbert Capital Management

Conclusion

There are both benefits and issues surrounding the use of the CPI as an accurate measure for inflation. For instance, the basket of goods used for the CPI is based upon purchases from a “typical household”, which is not a representative sample of all households. Thus, it is not an exact science, as it were. Likewise, the CPI can overstate inflation if it factors goods and services that consumers are using less of due to price increases. Substitution influences the weighting on the market basket, consequently resulting in a lower CPI. In addition, the basket of goods does not always factor the expenditure of new products that people regularly use. Consumption trends take time to be accounted for.

In essence, we are faced with a decision: accept the official CPI numbers provided by the Bureau of Labor Statistics (BLS), or choose alternate measures of inflation, thereby embracing the argument that official figures are inaccurate. Ultimately, whether or not the Consumer Price Index is a valid metric for inflation remains to be seen.

June CPI: Inflation continues to tick higher but outlook remains tame

U.S. consumer prices increased for the fifth consecutive month in June, led higher by a rebounding price of gasoline, although there was nothing in the latest release which should pose any immediate alarm for markets or consumers at large. The latest report from the BLS reported an overall increase in headline inflation of 0.3% month on month – an increase that was inline with nearly all economists polled prior to the announcement. Looking at the headline number on an annualized basis, inflation rose 0.1 percent In the 12 months through June, following an unchanged reading for the month of May.

Gasoline prices rose 3.4% month on month, following a 10.4 percent surge in May. Given the recent volatility in crude oil prices and inventory data in July, there could be scope for the influence of rising gas prices to subside in coming months. Oil is currently trading within the $50-60 / bbl range, well below the levels seen in May and June.

junecpi

Core CPI, which excludes food and energy related costs, increased 0.2 percent month on month following a rise of 0.1% previously. On an annualized basis, core CPI has now risen 1.8 percent.The June reading continues to highlight just how tame the inflationary environment is within the US economy at present. The strong dollar is helping to keep a lid on inflation by reducing the price of imports and wholesale costs. The strong US dollar has been been spurred partly by a flight to safety due to concerns in Europe and China, and partly by the market’s anticipation of a Fed rate hike later this year. We should expect to start hearing comments regarding the damaging effects of the stronger dollar by Fed officials in the weeks and months ahead should this trend continue.

The food index posts largest increase since September 2014

The price of food increased 0.3% in June, largely to an ongoing shortage in wholesale eggs which has caused a sharp jump in retail egg prices across the nation. Egg prices jumped 18.3% in June, the largest monthly gain since August 1973. Elsewhere, the index for meats, poultry, fish, and eggs rose 1.4 percent in June, with the beef index rising 0.9 percent. Food prices are likely to remain elevated in the coming months as the aftermath of the bird flu epidemic works its way through the supply chain. Wholesale food costs have been consistently increasing in PPI surveys, and these costs are likely to make their way down to the consumer in the weeks and months ahead.

Medical Price Inflation starting to cool off

Medical related inflation cooled in June which will be a welcome deviation from the overall trend in 2015. The price for Medical Care Services fell -0.2% in June and the prices for Medical Care Commodities remained unchanged month on month. Health care costs have been one of the largest contributors to inflation over the past 12 months, with both indices rising 2.3 percent and 3.3 percent respectively.

Rent Prices continue to Climb Higher

The shelter index climbed 0.3% in June, and 3% on an annualized basis as the supply of housing continues to shrink in key regions. Rent increases are also amongst the largest contributors to overall inflation in the United States within the past 12 months.

Outlook for Rates

This month’s CPI data contains no surprises, and the relatively tame reading in the core number on the back of the strong US dollar will likely stick in the minds of Fed officials in the weeks ahead. Globally, sentiment continues to wane dramatically given the continued turmoil in Greece, and increasingly China. While Greece appears to be on the verge of some sort of political settlement, the headline risk remains. In China’s case, there is a very real danger of investor sentiment turning, which could spell disaster for emerging markets overall. Latin American and South East Asian markets look at particular risk, especially on the currency front. The fate of these regions would be sealed in no uncertain terms should the Fed raise rates, and it is for this reason that it appears increasingly unlikely that the Fed will raise by year end, despite all of their rhetoric and expressed intention to do so.

Investment Road Map for a Deflationary Environment

Deflationary signals are beginning to crop up all over the world and investors need to sit up and take notice of these trends to ensure their portfolios are positioned to effectively deal with the potential onset of such an environment. Deflation is characterized by slumping demand, slower growth, and decreased credit growth which lead to falling prices throughout the economy. There are several investment strategies to help investors during periods of deflationary stress – here are some of the most popular strategies available.

Cash is King

Cash is one of the sure fire investment strategies during the onset of a deflationary cycle. The old cliche “Cash is King” definitely holds its own in these situations. Deflation triggers a mass scramble for cash in anticipation of crashing prices and slumping demand. Its often said that “He who panics first panics best” and this is definitely true in an increasingly overcrowded investment landscape. Having physical cash on hand can be a life saver during extreme periods such as government debt defaults, bank failures and widespread credit market collapse. Having cash can help you remain liquid during tough economic conditions. It means you aren’t overspending on goods that will have lower prices in the future, and you will have capital on hand to buy discounted assets.

Cash Stockpile

There is increasing concern about the value of fiat currencies globally and the unsustainable deficit and debt positions which most countries currently find themselves in. Many investors are turning to gold and precious metals in order to remain hedge against inflation and deflation – precious metals in this instance are acting like a currency and may also be of interest to certain investors.

Control Credit Risk with Municipal Bonds

Muni bonds generally have decent rates of return and are often backed by tax raising powers of the state or county issued – this leads to low default probabilities which is a highly sought after quality during periods of deflationary stress. Longer term bonds in general are a good investment strategy but you need to be careful about the credit ratings of certain companies. Companies which currently enjoy “A” rated debt securities can deteriorate quickly in a slow economy.

Avoid big ticket purchases

Large ticket items, especially if bought on credit like household goods, cars, trailers, and boats are unlikely to be wise purchases during the onset of a deflationary environment. Leverage as a general should be avoided during such periods. The problem with such purchases is that prices are likely to fall during an episode of deflation within the economy. This results in debt repayments on a depreciating asset over a potentially long time horizon. Under such a scenario you are effectively paying back dollars that are worth more than the ones you borrowed.

Reduce Debt

reduce debt
Paying off your existing debt can be one of the most important forms of investment during a periods of sustained deflation. As prices fall throughout the economy, the purchasing power of money increases which ultimately leads to your debt becoming more expensive. By increasing your debt repayments every month, you are effectively investing for the longer term by decreasing the value of your debt burden.

Invest in companies with large stockpiles of cash

The stock market is generally a place to avoid investing when facing the threat of an oncoming deflationary shock. Some stocks however will provide a level of security. Companies with large cash stockpiles are the most likely to benefit, as they face less pressure to deleverage. In a deflating environment such companies may be able to pick up cheap assets, as their competitors struggle with high debt burdens, solidifying their position within the market.

jobs

If history is any judge, stock markets tend to get hammered during the initial phases of a deflationary shock no matter how much cash or liquid assets they have on their books. With current stock market valuations at record highs, it’s unlikely that any stock would hold up to the violent selling pressure that a deflationary shock would create. The value of such stocks tend to come into their own during the second phase of a deflationary environment when the overall market has had time to adjust to the new economic realities, and rational investment allocation decisions begin to resume.

Overall, deflationary economic environments require investors to position their portfolios into more liquid, easily transferred securities. Deleveraging while there is still some semblance of market normality is often prudent as once a full scale deflationary spiral starts to unravel its often hard to avoid being caught up in increasingly irrational market moves.

February CPI Tops Expectations, Slowly Gears Fed Timetable Forward

The U.S. economy got a little economic boost today with a stronger-than-expected CPI reading for February, and a strong Purchasing Manager’s Index (PMI) that continued to project GDP growth.

Headline CPI and core CPI both came in 0.2% higher than January, as slight price hikes at the pump for refined products balanced out a general breather in the declines in some of the base commodities. The headline numbers had been tracking negative for the past three months, which everyone was pretty much ok with chalking up to crude oil. Just so long as GDP growth came in respectably, there wasn’t any reason to panic.

But core CPI (ex-food and energy costs) was already lagging behind Fed goals of around 2%, and already in the midst of sending deflationary ripples up the global goods chain, into…well, just about everything.

Muddled Waters for First Rate Hike

It’s created a tense chess match between investors and the Fed the past few weeks. It started just after the stellar (as in +295,000) February jobs report last month, when the consensus started to form that the Fed would have to act sooner rather than later in creating a interest rate normalization cycle.

The key first step of that cycle is getting us off the floor of zero percent rates – a stance that doesn’t befit a growing economy and presents what Yellen herself has called an “asymmetrical risk”.

U.S. Definitely Growing…But How Much?

Just as soon as we seemed to have some headway into a summer rate increase, nearly every economic indicator in the U.S. started been printing well below analyst estimates. In fact, the depth of our misses has hit a multi-year high, according to Bloomberg analysis:

Bloomberg surprise index

 

In light of this reversal, both investors and the Fed have had to take stock of things. First quarter GDP estimates continue to be ratcheted down – from the 2.5% – 3.0% level I highlighted last month (a number that was freshly lowered at the time) to an average Q1 GDP estimate of about 1.5% today.

Cranky Markets are Volatile Markets

It’s why we’ve seen a spike in volatility around every asset class – fixed income, forex, commodities, and equities have all been bumping around trying to align their compass to the next clear trend line. Would the Fed remove “patient” in the March FOMC meeting? Was September the new June (for the first rate hike)? Was 2015 off the table entirely?

Answering these questions is challenging enough in isolation, but it’s been exacerbated by the stunning rise the the USD index, which alters true price action in commodities and long bonds. The surging U.S. dollar is a de facto rate hike. It lowers the cost of imports dramatically (a deflationary force), and it makes our exports more expensive overseas.

And while the realities of pricier U.S. exports certainly hurt some companies more than others, the simple fact is that close to 50% of the total revenues of the S&P 500 member companies is derived in a currency other than the U.S. dollar.

2014, Part Deux?

It’s quite astonishing how much the first quarter of this year is looking like the first quarter of last year. Tick by tick, indicator by indicator, we seem to be replicating that market environment.

This time last year we were watching interest rates hit new lows, but convinced the party had to end any moment – inflation was coming, and we needed to position ourselves away from fixed income and into equities, gold, and other commodities. Fixed income turned out to deliver stronger returns than even equities did.

GDP looked to be on track for a good start to the year, but then a bout of really bad whether caused us to actually contract as an economy in Q1. Most of the top analysts said “don’t worry, we’ll be strong in the back half of the year”, and sure enough we were. The U.S. turned in over 4.5% growth in the next two quarters.

Looking around today, it’s much the same setup – so far. The key differences between then and now are this:

1) the unemployment rate is lower than last year; we have clearly moved close enough to full unemployment in the Fed’s eyes that it’s no longer an impediment to a rate increase. That box is checked off.

2) the USD is much stronger (10-20% or more) against every major global currency. As I’ve discussed, this move alone is the equivalent of a 25-50 bps rate hike.

In fact, if the dollar hadn’t been zooming so hard the past six months, there’s a chance the Fed would’ve put a token 25bp hike out there last week. Instead, Yellen reminded us that the Fed isn’t there to make things easy for investors, saying the Fed “can’t provide and shouldn’t provide” certainly to markets when it comes to the timing of rate hikes.

We don’t seem to be in any danger of that.

 

Different ways of measuring inflation in the U.S.

Inflation is one of the most important economic indicators available to consumers and investors as it gives a strong signal how the economy is currently performing, and perhaps more importantly, a strong hint at which way monetary policy is likely to swing in the coming months. The Federal Reserve analyzes inflation trends in detail, and any sign that inflation is getting either too high, or too low will often be met with a swift policy response; usually an increase or decrease in interest rates. Changes in interest rates affect every aspect of the economy including mortgages, student loans, business loans, savings accounts, and government debt.

In light of this, it is crucial that you gain a strong handle on the numerous ways that inflation is measured in order to give yourself an insight into the potential direction of monetary policy at the Federal Reserve, and how such policies are likely to impact you as an individual. Althought we use the CPI for the sake of our calculator, we understand that there are various other ways to calculate inflation and each way has its pros and cons…

Official Government Inflation Measures: CPI and PPI

The Bureau of Labor Statistics has the unenviable task of producing inflation statistics within the United States. They do this by collating a vast series of data from the economy in order to produce two key inflation indicators – namely the Consumer Price Index and the Producer Price Index.

The Consumer Price Index (CPI), is a measure of price changes in a vast array of consumer goods and services. The CPI measures price change in the most popular products and services purchased by American consumers (basket of goods and services). The CPI is often used a reference point for wage adjustment purposes. The CPI is crucial to monitor as it highlights how much the purchasing power of the dollar increases or decreases. This has wide reaching implications throughout the economy.

basketofgoodsweightscpi

Producer Price Indexes (PPI) – are a collection of indexes that measure the average change of selling prices by domestic producers of goods and services. PPI is often followed closely by market analysts as an early indicator of changing trends within the economy. Falling producer prices mean businesses are finding it is difficult to sell their products and are often offering heavy discounts. This can lead to potentially deflationary spirals which plunge the while economy into recession.

Official Government statistics are viewed with skepticism by some parts of the investment community – it is believed that the BLS and the Government have an incentive to “massage” the official inflation figures to suit their own economic message or agenda. Often these analysts and market commentators will use alternative indicators in an attempt to cut through any government bias.

Alternative Measures of Inflation

Gold has been an historically important indicator of inflation for thousands of years and is seen by many as the only real form of enduring money. The purchasing power of gold has endured throughout history without exception. In the past two centuries alone, the purchasing power of gold has held up through countless revolutions and two world wars, fiat currencies by contrast, have come and gone several times over! It is unsurprising therefore, that many investors and market commentators will look at the gold price to gain insight into the overall health of an economy. An elevated gold price highlights stress and distrust within the overall financial system, and a distrust with the monetary policy makers in general. Gold prices tend to rise if inflation is expected to increase. Gold overall is a valuable indicator for providing an inflation indicator free of government bias.

Gold-vs-Inflation

Growing distrust of official statistics has also given rise to independent organizations which keep track of their own data to generate inflation forecasts. One such organization is shadowstats.com which aims to cut through bias in government statistics and forecasting to provide a more balanced view of inflation within the economy.

Cover all Bases

As always, the devil is always in the detail. There is no single measure of inflation which you should accurately rely on to make decisions for your business, or investments. Increasing bias in Government statistics make it necessary to look beyond the official figures to gain a more comprehensive picture of what is really happening with regards to inflation. As we have discussed, by mastering all the different ways to monitor inflation, you will be able to make increasingly informed decisions and opinions.

Which measure of inflation do you like to use? Let us know by commenting below.

 

 

Fed Minutes – Anybody Feel Smarter Today?

In a week where there wasn’t much in the way of high-impact macro data, I along with other inflation hounds was left to pore over what were some very diffuse Fed minutes yesterday. There seems to be a communication breakdown – figuratively and literally – in what was the longest minutes report in recent memory (over 8000 words!) yet also the hardest to interpret.

After all, the bond markets have been moving crazily; it seemed the smell of inflation was in the air following a strong jobs report and a 35 basis point rise in the benchmark 10-yr over a two week period.

Economy Cliff’s Notes

In a word, the FOMC minutes were dovish. Janet Yellen, her voting cohorts, and their staffs just can’t find enough data points to make a strong case for either inflation or broad growth. We clearly identified this reality last week, noting that things were becoming “more opaque by the day”. While there was a slight tickup in weekly pay, retails sales continues to print weak while headline and core CPI and PPI are well, well below the Fed’s 2%-ish target.

The Producer Price Index (PPI) for January came in yesterday at a 0.8% drop after a 1.1% annualized growth pace in December. Most vitally, we’re now on pace to turn in exactly zero growth Y/Y in the PPI. As with every inflation metric right now, it’s being thrown off kilter by the fall in crude oil.

For now, macro analysts like Michael Hanson over at BofA Merrill are saying that while we may see negative headline inflation, it’s “probably not deflation” as seen by the Fed. This is backed up by recent comments from Yellen, who has called the spike down in energy prices as “transitory”, while Philadelphia Fed President Charles Plosser noted that “I don’t see deflation as a risk in the U.S. economy”.

Rock and a Hard Place – Stuck in the Middle With You

I’m in the camp with most people who believe that the Fed would love nothing more than to get at least 1-2 rate hikes passed along this year. They would love to get the credit markets operating in a more normalized capacity, and they would certainly love to have the extra arrows in the quiver that a 0.5% – 1% Fed Funds rate would provide.

This stance doesn’t require one to be a hawk or a dove; it’s just good business for the Fed to have a full set of levers at their disposal. But there is real damage that could be done to the long-term viability of the Fed if they were to raise rates this summer, only to find that GDP growth has vanished and they’re forced to re-cut rates.

And as I noted last week, there is a very fine line there. The PPI results will in many ways flow through to the CPI over the next few months, and as I write this crude oil is down another 4% or so today and we may see the largest crude inventory build in history later Thursday.

As it stands now, we are the only advanced economy on the planet that is forecasting a rate increase in 2015. Granted, we are also the healthiest, so there’s a case to be made that we should be the first ones out of the gate. But for now, the Fed is admittedly (for the first time in over a year) looking overseas at risks in China and the Middle East, and even looking with some fear at the fixed income ETF market, of all places.

Investor Implications

It’s prudent for the Fed to be considering the near-term impact of falling commodities, just as it’s prudent to see them within the context of stagnant global growth. Neither are tasks we wish the Fed was spending so much time on, but the times are what they are; there’s not exactly a dog-eared playbook of what to do at this point. Just a compass.

Anybody that is out there with a strong opinion on whether the Fed is doing the right thing will have to cherry pick their metrics and indicators to prove their position. Fed Funds futures bettors scaled back their odds for a June rate hike, following the “let’s punt the ball” tone of the January FOMC minutes.

I tend to agree with a couple of analysts that have suggested the surging U.S. Dollar is a de facto rate increase already, as it will push down our exports a bit. In the meantime, the Fed – like the rest of us – will sit and wait to see if GDP is hanging in there. This continues to look a lot like Goldilocks for equities, just like the past few years.