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Want to Measure Actual Inflation? See the Core/Headline CPI Spread

As we have previously discussed, inflation remains contained to the rest of the world ex-USA. Globalization be damned, there may be rapid price rises in most of the world, but there is no inflation in the U.S., thanks to a combination of hedonic adjustments and the absurd focus on the core rate.

Whenever I hear the phrase "excluding volatile food and energy" I just laugh. Can a pricing group be considered volatile if it merely goes up each month in an orderly fashion -- for years and years?

That's not volatility, thats a trend.

One way to actually measure how absurd the US core inflation measure is to look at what has happened to the spread between headline CPI and Core CPI. If Core CPI is understating inflation, than the spread should be widening. If it is accurate, the overall ratio between the two should be relatively steady.

What does the data show? The spread has increased substantially since the US adopted an ultra low rate/easy money policy under Greenspan (now affiliated with bond giant PIMCO). Since the easy money policy of the 1990s, and the  rate slashing of the 2000s, it is no coincidence that the spread between the headline number and the core has grown dramatically.

If you want to trace this widening spread back to its origins, it coincides with implementation of Boskin Commission changes in CPI. (About as intellectually dishonest analysis of Inflation as has ever been penned -- its goal was to reduce Social Security payments and avoid bankrupting the US Treasury -- not measure inflation accurately). Since then, the spread between the core and headline data have only grown further apart.

This simply reflects the government's BLS inflation data diverging from reality.

Core CPI flatlined over the past 8 years because that is how it was constructed -- to not show inflation. However, the absurdity of the adjustments in inflation measures is revealed in the widening spread between Core and Headline:

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CPI minus Core CPI (1980 to present)
click for larger chart

Courtesy of M. Ramsey King Securities

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Notice how tightly the two data series coincide (top chart) in the latter half of the 1980s and all of the 1990s? See how that starts diverging in 2001?

Bill King points out: "Targeted inflation may be the headline CPI, or a derived core inflation measure. In either case central banks should be aware of the sources of error and bias in their country’s CPI"

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If you really want to econo-geek out on this stuff, there are several good resources for taking apart how this data is constructed:

Core Inflation Measures and Statistical Issues in Choosing Among Them
Mick Silver
IMF Working Paper April 2006
http://www.imf.org/external/pubs/ft/wp/2006/wp0697.pdf

PCE Inflation and Core Inflation
Julie K. Smith
July 6, 2006
http://ww2.lafayette.edu/~smithjk/PCE%20core%20inflation%20070606.pdf

But the bottom line is that the US measures of Inflation, especially the core levels, are constructed to diverge from reality, and understate price rises. That is seen in the headline CPI/Core spread.

Wednesday, May 16, 2007 | 06:46 AM | Permalink | Comments (24) | TrackBack (2)
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Comments

Barry,

Excellent post. The real test of an inflation measure: how you calculate your real returns from T-bonds. Do you use core inflation to determine the lost purchasing power of the bond face value? Or headline?

Headline, of course. And on that basis, bond returns have been rotten the past three years. That means two things: 1) the bond market has consistently gotten its inflation forecast wrong; and/or 2) the Chinese don't care that their real returns are so paltry.

To the extent its 1), Greenspan, BB and the Boskin commission can be congratulated for successfully pulling the "core" wool over bond traders' eyes.

Posted by: David Pearson | May 16, 2007 7:40:03 AM