When most of us think about inflation, we think of the prices of the things we buy regularly. The government supposedly measures that in the CPI – Consumer Price Index.
I think that intuitively most of us experience a higher level of inflation that the government reports.
There’s a reason for that. The government doesn’t measure inflation, at least as classically defined. The classical definition is a rise in the “general” level of prices. That should include all things that are bought and sold – that have prices.
The CPI doesn’t do that. It measures a narrowly defined, and statistically manipulated basket of consumption goods and services. And the government does its best to suppress the inflation rate of those items. That’s because the CPI was never intended to measure a rise in the general level of prices. It was intended as a means for indexing the cost of labor contracts and government contracts in eras of high inflation.
Given that purpose, government statisticians have habitually looked for ways to get to these numbers to understate actual inflation. They use hedonics to substitute lower priced goods for higher priced goods when prices are rising because in theory consumers will make that switch. But if we wanted to measure general inflation accurately, wouldn’t we survey the prices of the same goods over time.
Contrary to conventional wisdom, this is not a benign inflation picture. It indicates that the Fed’s current target rate is still at a negative real rate, that is, interest rates are below the inflation rate. As long as short term interest rates are below the inflation rate, rate increases will stimulate even more inflation, not suppress it. That will create a vicious cycle until rates become punitive, at a real rate high enough to slow consumption.
Some years ago I developed an alternative CPI measure that replaced the phony rent component of CPI called Owner’s Equivalent Rent, with the FHFA house price index. This index has shown that if housing were included in the CPI it would be rising at about 1 percentage point more than CPI. Because this measure includes food and energy, I’ve plotted it with headline CPI.
The adjusted index was only below the Fed’s target 2% inflation rate during the oil price collapse of 2014-15. But it has been back above that level since January 2016, and it has been persistently 3.5% or higher.
None of this even begins to approach the stupendous inflation of prices, which economists completely ignore, despite the fact that inflated asset bubbles eventually collapse and lead to financial system crashes.
As the Fed tightens, it remains well behind the curve. The inflation numbers will probably get worse as long as interest rates remain below the actual inflation rate. Historically, rising rates have stimulated even more inflation until rates get high enough to choke the economy. We’re a long way from that. It will keep the Fed on course in its program of removing money from the system as it “normalizes” its balance sheet.
The only way to play that from a long term investment standpoint is to stay away from stocks and bonds, and continue to hold and roll Treasury bills as they mature and interest rates rise. The time will eventually come to buy bonds and stocks again. But it’s still a long way off.
Meanwhile we can look for trading profits with that amount of our capital that we’re willing to risk. You can work out how much risk is appropriate for you with your financial advisor.
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