Confusion about inflation abounds in mainstream media reporting. That confusion is a result of the fact that mainstream economists and the Fed solely focus on narrowly defined, arbitrarily constructed measures of the prices of consumer goods only. If you only look in places where there’s little inflation, or use indexes that are not standardized to measure the same goods over time, you end up ignoring the things that are inflating, and understating the inflation that does exist in consumer prices.
The Fed is largely to blame for the confusion. It has targeted a 2% inflation rate. But it uses a benchmark, the core PCE, that is the most understated of inflation measures. It ignores actual housing prices and only includes personal consumption goods. To make matters worse, when an index component is rising faster than cheaper substitutes, the index formula reduces the weighting of the goods that are rising fastest.
The thing is, the Fed is perfectly aware that it’s underreporting inflation.
I’ve uncovered a smoking gun – well, anyway, a chart that proves they know the real numbers.
The question is – why the cover-up?
I’ve got my own theories on that (and naturally, a plan of action for you and your money).
First…The “Smoking Gun” That Shows Real Inflation At 3%, Not 2%
Even the NY Fed itself recognizes that these measures which purport to show inflation falling short of the Fed’s target, don’t reflect reality. It publishes an unknown series called the Underlying Inflation Gauge (UIG). Since 2012 it has rarely been below 2%, and it is currently at 3%.
Source: NY Fed
There it is, in black and white and tan and blue. The Fed knows. They’re just keeping very quiet about it.
Prices Are Rising Much Faster Than The Fed Would Have You Believe
The core PCE may be a measure of how fast some households’ cost of living is rising. Maybe those households do substitute similar, cheaper goods when prices rise. But how does that measure actual inflation if it does not measure the same basket of goods over time? If you subtract steak and add hamburger when steak prices are rising, the result is an understatement of the inflation rate of the same goods over time.
The CPI has the same problem. In fact, the CPI was never intended to measure broad based inflation. It was intended as a basis for indexing of labor contracts and government salaries and benefits. The unstated goal has always been to keep those increases to a minimum.
On that basis, the BLS removed housing prices from the index in 1982, because raging housing inflation was pushing up CPI too fast. It substituted a measure called Owner’s Equivalent Rent (OER) that is completely ginned up. It is supposed to measure what owners think their homes would rent for.
The bottom line is that OER consistently understates the actual rate of home price inflation by at least half, and sometimes more than half. Today, that results in understating CPI by about a full point. When core CPI, excluding food and energy, rises by a reported 1.5% per year, the actual rate would be around 2.5% if house prices were included.
Moving up the inflation spectrum, we see home prices as conservatively measured by the Federal Government’s FHFA index, inflating by 36.5% since 2012. That’s 5.8% per year. The NAR’s index shows the rate even higher than that. FHFA shows the current inflation rate over the past year to be 6.4%. The NAR shows closer to 7%. It is not statistically massaged to suppress the inflation rate as the FHFA measure is.
Not coincidentally, the inflation rate of single family housing correlates perfectly with the inflation rate of the M2 Money Supply measure. As Milton Friedman famously said, “”Inflation is always and everywhere a monetary phenomenon.” I would add, “So what if it isn’t showing up in the artificially suppressed indexes of consumption goods! It is showing up everywhere else.”
Multifamily housing prices are up 55% since 2012 through the third quarter of this year. That’s 9.2% per year.
Finally stock prices have inflated by a sizzling 97% since mid 2012. That’s 13.1% per year, including almost 19% in the past 12 months.
Wall Street would argue that earnings per share have risen during that time. So let’s normalize for that by looking at the PE ratio of the S&P 500. That’s the price of $1 of earnings per share. In mid 2012, the PE ratio of the S&P 500 was 16 (Source: Macrotrends). Based on current EPS and price level, the S&P 500 PE ratio is now approximately 25. That means that the price of $1 of earnings per share has risen by 56% since mid 2012. That’s an annual inflation rate of 8.5%.
Of course economists and the Wall Street PR machine never use the word “inflation” in regard to housing or stock prices. To them, it’s always “appreciation” or “growth.” In reality, there are no purer manifestations of monetary inflation than in these things. The fact that their growth rates approximate the growth rate of the money supply, is evidence of that.
It’s no accident either that the inflation has mostly shown up in assets. The sole transmission mechanism of central bank money printing, in the US in particular, is the purchase of securities from Primary Dealers. The first place the money goes when the Fed buys securities is into the Federal Reserve checking accounts of the world’s largest securities trading firms. The financial markets retain most of that cash. After the initial deployment of cash into stocks and bonds, the only trickle down is to the real estate finance industry, where we have seen the results in the massive reflation of the housing bubble.
Securities firms and their corporate clients played games with that money to enrich the corporate capos. Little of it was used to finance real investment, and virtually none of it was invested in labor. In fact, labor no longer has any market power, so it got virtually nothing. Because labor’s spending power was held down, so were the prices of goods that they purchase. Because economists and the media look only at consumer prices it give the impression that there was no inflation.
But when we look closely, there’s still plenty of evidence that prices are rising faster than the Fed and its media handmaidens would have us believe. We know that housing prices are rising by at least 6% a year, when the substitute measure used to represent housing in the CPI is only going up at 2-3%.
And we also know that the BLS is understating the consumer goods inflation rate because the underlying wholesale price of consumer goods has consistently risen at a rate about 1% or more higher than CPI.
To illustrate, here’s a comparison of various measures of consumer prices.
While core PCE is rising at only 1.4%, and core CPI at 1.7%, the wholesale prices of core finished consumer goods are going up at 3%. These prices are volatile, but a gap of 1% in the inflation rate between wholesale and retail is typical. Would government statisticians, the Fed, and Wall Street shills have us believe that retailers never pass along their rising costs?
I don’t know about you, but I don’t believe it. Amazon and Walmart wouldn’t stay in business for long if they did not pass along their cost increases.
The Fed Senses Danger – and Actions Speak Louder than Words
Whether the Fed muddies the waters on inflation by simple happenstance or on purpose isn’t clear and doesn’t matter. I’ve hypothesized before that they’re just nuts.
“Inflation” as they measure it, has consistently undershot the Fed’s 2% target. What matters is that the Fed is tightening policy anyway.
I believe that that is largely because the Fed really is concerned about the inflation that mainstream economists and the clueless financial media don’t consider to be inflation. That is asset bubble inflation. The Fed keeps talking about it and saying that it isn’t a problem, which of course means that it is a problem, and they know it. That includes the massive inflation of stock prices.
The classical definition of inflation is a rise in the general level of prices. That definition does not say “a rise in consumer prices only.” It does not say “a rise in prices excluding asset prices or commodity prices, or housing prices.” Yet the Fed and mainstream economists focus only on those things. They focus only on measures that exclude items that are inflating. Here’s a chart showing what they look at, versus what they are reputedly ignoring (which I think they are only pretending to ignore).
In this chart I have indexed each series to its average in 2012. That’s when the Fed first enunciated its 2% inflation target. In reverse order, the Fed’s favorite measure, Core PCE, is up a total of 8.5% since 2012. That’s an average compound rate of 1.5% per year. This was the excuse given for keeping interest rates at zero until recently. But nothing has changed in the past year. Core PCE is up just 1.4% over the last 12 months.
The Core CPI numbers are similar. It has risen by 10.3% since the Fed announced its inflation target in 2012. That’s 1.8% per year. In the past 12 months it has risen by 1.7%.
So if “inflation” is falling short of the Fed’s target, why is the Fed tightening? We’re kidding ourselves if we think the Fed isn’t paying attention to asset price inflation and the tremendous dangers asset bubbles present for the financial system.
So what’s the point? It’s that the Fed knows that inflation is heating up. It will continue to tap the monetary brakes in the months ahead. If the real inflation trend starts to seep into the CPI data, the Fed may even become more aggressive in draining funds from the banking system. Under its balance sheet “normalization program, it will gradually increase its draining operations to $50 billion per month next October. If CPI and PCE heat up it could go even higher than that.
There’s no doubt that the market has built up a speculative head of steam. We can ride that wave a bit longer as the S&P heads toward my cycle theory price projection of 2750-2800. But the risks are growing that we’ll face a severe adjustment later in 2018. I’d still keep my goal of reaching 60-70% cash by the end of January, or the end of March at the latest.
I wouldn’t go short until the first clear technical signs that the mania has broken. Rule number 2 remains ascendant for now. The trend is your friend. Don’t fight the tape. But the time is coming when Rule Number 1, “Don’t fight the Fed,” will rule again. Manias are powerful and can be surprisingly persistent as the use of speculative leverage goes wild. But the money eventually runs out. I’ll watch the technical indicators closely for any signs of that and give you a heads up right here when I see them.
The Short Term LAMPP Has Edged Back into Yellow Territory – But Don’t Be Fooled
The long term LAMPP edged up slightly in the past week as the Federal Government slows debt issuance under the debt ceiling. At the same time, the Fed settled $24 billion in forward MBS purchases last week. That added cash to Primary Dealer coffers.
The monthly settlement of Fed MBS purchases will decline over the next year. When the debt ceiling is finally lifted and the Treasury returns to the market at full speed, the LAMPP will turn red within weeks. The reduction of issuance will keep the indicator on green for the time being.
In January total Fed draining operations will increase to a total of $20 billion, from $10 billion. This will drain cash from the banking system.
$97 billion in Treasuries on the Fed’s balance sheet will mature in the first quarter. The Fed will tell the Treasury to repay $36 billion of that. That money will disappear from the banking system. It will reduce the amount of cash that feeds demand for securities.
If the Treasury resumes issuing new debt at the rate the TBAC has forecast in Q1, then the long term LAMPP should flash a red signal in roughly 4-5 weeks from the time the debt ceiling is lifted. However, as long as new Treasury issuance is restricted, the removal of supply from the marketplace will be a bullish factor for stocks.
The short term LAMPP has edged back into yellow territory. Long side trades in the Wall Street Examiner Pro Trader model trading portfolio have done very well in recent weeks. Short side trading picks have been a drag on performance. I will continue to look for good short term setups on both sides of the ledger.
In the meantime, I would not be buying long term positions. Short term trading from the long side should be watched closely for support breaks. Only when the Long Term LAMPP turns red, would I concentrate on trading from the short side. Prior to that, I would pick and choose shorts cautiously.