IronStats

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.

 

What exactly is the Consumer Price Index (CPI) and how is it calculated?

cpiCPI stands for Consumer Price Index, and it is a measure of inflation. It is calculated by measuring the change in a specific group of goods and services over time. The CPI is calculated by the US Bureau of Labor Statistics.

What the CPI Measures

The CPI measures the spending habits for two different groups. The CPI-U measures the spending patterns of all urban consumers. The CPI-W measures the spending patterns of urban wage earners and clerical workers. The spending patterns of people living in rural areas, farmers, members of the armed forces and those institutionalized in prisons or hospitals are not measured. The group of all urban consumers represents about 87 percent of the entire population of the United States. The people who comprise the CPI-W are a subset of the CPI-U.

What the CPI Includes

The CPI includes eight major groups of expenditures. They are:

  • apparel, which includes clothing and accessories like jewelry;
  • education and communication, which includes school tuition, telephone and internet services, and computer software and accessories;
  • food and beverages, which consists of grocery items as well as dining out;
  • housing, which includes rent or mortgage payments, utilities and furnishings;
  • medical care, including prescriptions, hospital services, doctor’s services, and dental and vision products and services;
  • recreation, including admission to spectator sporting events, toys, pets, and sports equipment;
  • transportation, comprised of vehicle leases and purchases, gas, insurance, and airplane and train fares; and
  • other goods and services, such as personal services like hairdressing, funeral expenses, and tobacco and smoking products.

Taxes on items purchased and excise taxes are included in CPI, as are user taxes like tolls. Income taxes are not included. Investments and savings vehicles are not included.

How the CPI Data is Published

The CPI data is published nationally and by region every month. The regions are the Northeast, Midwest, South and West. The data is also published by metropolitan area. The Chicago, Los Angeles and New York data are published every month. Data for the other 11 metropolitan areas are published every other month. These areas are Atlanta, Boston, Cleveland, Dallas, Detroit, Houston, Miami, Philadelphia, San Francisco, Seattle and Washington DC.

How the CPI is Used

The CPI is used to measure inflation. It is used by government agencies and entities to measure the effectiveness of fiscal and monetary policy, and to determine when that policy needs to be adjusted. It is used by government, private industry, labor unions and individuals to determine how effective current economic policy is.

The CPI is used to determine purchasing power. When you hear the terms ‘in today’s dollars,’ or ‘adjusted for inflation,’ the values discussed have been adjusted by using the CPI in order to reflect true purchasing power, or the amount a dollar will buy, at different times in history.

The CPI is used to adjust Social Security and other income payments, and to adjust the level of income required for eligibility for government programs. Retirees, whether they collect Social Security or a military or civil service pension, recipients of food stamps, and children who receive free or reduced price school lunches are all affected by changes in the CPI.

The Difference Between CPI and a Cost-of-Living Index

The CPI is often referred to as a cost-of-living index, but there is a difference. The CPI reflects what consumers are actually buying, while a cost of living index reflects the amount of income necessary to maintain a certain standard of living.

When consumers have less income, they tend to substitute less expensive versions of the same item in their budgets. Since the CPI reflects the cost of what they actually buy, this measure may drop when substitutions are made. A cost of living index, on the other hand, would reflect the cost of a certain item over time, which will almost always go up.

How Does CPI Affect Inflation?

CPI data is used to calculate inflation with the following general formula:

  • CPI1 = initial CPI
  • CPI2 = final CPI
  • Inflation = (CPI2-CPI1)/CPI1

Since two CPI values define inflation, the consumer price index has a large effect on reported inflation.

CPI and Inflation Calculation

The following example will illustrate how different prices, baselines and CPI values affect reported inflation.

  • Assume a mix of products with average product price indexed to CPI of 100 in a Baseline Year.
  • Three years later, the same products have an average price index of 108. This means that three years after Baseline Year, buying the same product mix would take eight percent more money than it cost during Baseline Year. Note that this is not a reflection of product quality, but purely a function of decreased purchasing power of Baseline Year Dollars.
  • Six years after Baseline Year, CPI is determined to be 130.
  • InflationB-3, between Baseline and third year, would be calculated as (108-100)/100 = .08 or eight percent.
  • Inflation3-6, between third and xixth years, would be (130-108)/108 = 0.204, or 20.4 percent
  • InflationB-6 is: (130-100)/100 = 0.30 or thirty percent.

In this example, inflation calculations in three-year intervals were 8 and 20.4 percent. Yet, inflation over six years measured cumulatively was thirty percent. This was more than a summation of 8 and 20.4, which comes to 28.4 percent. As is evident here, clever choice of CPI data can give “honest” yet differing inflation figures.

Baseline CPI and Inflation

The choice of CPI baseline is arbitrary. A baseline that will give the most favorable results could be chosen over one that might be more accurate in reflecting the economic reality of shifting consumer purchasing power with respect to a basket of goods and services. For instance, baselines set during recessions or asset bubble peaks would both give very skewed inflation data.

Qualitative Discrepancies

The BLS calculates CPI from product price surveys in select metropolitan areas. More populated and economically dominant areas such as those centered around New York City and Los Angeles are weighed more heavily than smaller population clusters such as those centered on Memphis and Anchorage. Thus, economic realities prevalent for many people in small-town and rural areas will be under-represented in favor of large metropolitan areas.

CPI fails to take into account purchases of investment securities such as stocks. Recent U.S. financial history illustrates this phenomenon:

  • The average CPI in 2009 was 214.537, increasing to 232.957 by 2013.
  • 2009-2013 inflation comes to (232.957 – 214.537)/214.537 = 0.086, or 8.6 percent.
  • The beginning price for the S&P 500 index in 2009 was 903.25.
  • Ending S&P 500 price at the close of 2013 was 1848.36.
  • The S&P 500 index rose (1848.36-903.25) / 903.25 = 1.046, or 104.6 percent.

Some experts have stated that the S&P 500’s meteoric rise between 2009 and 2013 was not justified by underlying economics, instead being a result of loose monetary policy on the part of the Federal Reserve. It was predicted that the money would percolate to consumer products, stoking inflation. This has not happened, with 8.6 percent inflation being rather mild in a four-year time period. Rather, the inflation” went into the stock market. As such, investors had to contend with the possibility that artificially inflated stock prices would make positive returns unlikely in the future.

Conclusion

CPI has a large effect on inflation calculations. CPI is great overall catchall of consumer purchasing power over time, though it has some weaknesses. Also, it is important to note that CPI ignores some facets of consumer purchases, such as investment vehicles, that have a substantial effect on future purchasing power and quality of life.