TBTF November 8, 2010 - Rise, Rise, Rise

‘Rise, Rise, Rise, Keep on risin’ Rise, Rise, Rise, Yeaheaheaheah’ (Soul Providers – 2007).

Over the weekend Bernanke defended the Fed’s expansion of record stimulus at a conference in Jekyll Island, Georgia, as he has done over the past 4 days, ever since the announcement of QE2. Instead of commenting on the supposed merits of the program Bernanke should take his cue from Ex-Fed President Gary Stern, who eloquently described what must be the prevailing opinion amongst the Fed policy committee members:

“I would have voted in favor of it mainly because I think it’s worth a try and might have marginally positive effect on the rate of growth of the economy and unemployment”

In other words, why not, if it doesn’t help it won’t hurt. And that is exactly where I strongly disagree with the Fed at the moment, in my view it will hurt because it will spark uncontrollable inflation. Bernanke actually made some comment on inflation during a panel discussion:

“I have rejected any notion that we are going to raise inflation to a super-normal level in order to have effect on the economy…, our credibility must be maintained, it’s critical for us to maintain inflation at an appropriate level. Our purpose is to provide additional stimulus to help the economy recover and to avoid potentially additional disinflation which I think we all agree would be a worse outcome”

Obviously Mr. Bernanke doesn’t see inflation as a problem, he probably feels he can always raise interest rates to contain inflation, inflation that is as of yet nowhere to be seen according to the Fed Chairman.

I disagree with him on both points. If  inflation starts to become a problem he could very well be able to raise interest rates, for that to be a possibility it means all his stimulus must have worked, economic growth will have to be at or above average levels and unemployment must be down, for if not he will stop any economic recovery in its tracks. The federal deficit will also have to be brought down to sustainable levels, else a raise in real-interest rates will only aggravate the financial burden this administration is transferring upon the shoulders of the next generation. So, even though Ben might be convinced inflation won’t become a problem I don’t share his optimistic view.

The one thing Mr. fed and I will be disagreeing on even more is the gauge for inflation. According to him inflation is too low at the moment and there are no signs that inflation will rise to his target of 1.8% - 2% in the near future. I will make the bold statement right here and now that inflation is already here, it’s not going anywhere and it will get worse, much worse. How can we have such different views on inflation you might ask, I can explain it very easy, Mr. Bernanke looks at the Core-CPI and I say that the core-CPI is not a real measure of real-inflation, but an easily manipulated index devised to make the lives of Central Bankers easier.

What exactly is the CPI and how does it measure inflation. On the website of the Bureau of Labor Statistics, the government agency that calculates the inflation gauge, we can find that the CPI is the “Change in prices paid by urban consumers for a representative basket of goods and services”. So far, so good.

The goods and services in the CPI index are categorized in the following 8 groups:

1.      Food and Beverages

2.      Housing

3.      Apparel

4.      Transportation

5.      Medical Care

6.      Recreation

7.      Education and Communications

8.      Consumer Expenditure

These 8 groups are then each assigned a weight within the Consumer Price Index and this is where the first interesting observation can be made. The group with the highest weight is Housing 42% of the CPI (within the Housing group Fuels and Utilities in and around the home makes up for 5% of the 42), next come Food & Beverages 15%, New and Used Motor Vehicles 6% and Motor Fuel 4.5%

As you can see, Housing, which has seen prices slide or stabilize in the last 2 years has an almost 40% impact (if you take out heating oil and electricity) on the CPI. Used Motor Vehicles, a big ticket item, not something consumer go out and by again and again each month weighs for 6%. So, almost 50% of the CPI is made up by items that do not change much in value in normal economic times, and have certainly not been going up in the last 2 years.

Volatile goods like Fuel and Food & Beverages make up for only 20% of the index and this is what people have to buy week in week out, year in year out.

So it seems there is a mismatch in what the CPI says the prevailing Inflation-Rate is and what people feel in their wallet. The $1.500 in rent or mortgage payments is not what make inflation, it’s what you can do with the money that is left after you paid for the roof over your head. Can we still get food on the table, can we fill up our car this week or are we going to have to take public transportation to go to work.

To make matters even worse, central bankers and politicians around the world don’t use the CPI as the measure of inflation, but the Core-CPI, the CPI number excluding Food and Energy because these components are too volatile. So when gas doubles at the pump it’s not real inflation for the theorists among us, but it hurts in my pocket anyway, it hurts a lot.

I can understand that politicians and central bankers cannot adjust their chosen policies anytime someone corners the Wheat- or Oil markets, but if and when commodities have been rising steadily but surely over a prolonged period of time it seems rigid and wrong to hold on to the perception that inflation can be measured by Core-CPI. And this exactly what has been happening ever since QE1, QE-lite and now QE2 have been announced. Raw goods have been rising in price steadily, they have had an impact on the Producer Price Index (+4% YoY in September and expected to be up 4.6% in October versus 1 year ago), but because we are still in a recession (that’s a disagreement I have with Mr. Bernanke that will have to wait until another time) producers haven’t been able to pass those elevated prices on to consumer, just yet.

The following graph shows just how much prices of basic raw materials have risen since March 2009 (when QE1 was announced), through the latest round of QE. It takes not much imagination to see that this huge run up in raw goods will raise inflation numbers sooner rather than later. We can only hope the good Dr. Bernanke won’t be stuck in his simplistic view of inflation, as measured by the CPI-ex Food & Energy, or the man in the street will be victim of ‘Zimbabwian-esque inflation, before the Fed chairman acknowledges inflation has crept up past the 1.8% - 2% target and will proudly announce his master-plan has worked and QE15 will begin to be unwound.

Happy Hunting & Let’s Be Careful out there!!!