Inflating the Numbers

How can inflation be so low over the past few years if we see rising energy prices, ever-increasing medical costs – and especially, the cost of housing rising so dramatically? John Mauldin looks to answer this questions – and more…

For the first time we see inflation actually showing the results of rising energy costs, and the number is ugly. But it is not as ugly as it could be. Like the making of sausage and laws, looking at how the Consumer Price Index is calculated it is not pretty.

"A 12% jump in energy prices in September caused the CPI to rise by

1.2 % last month, the largest monthly increase since a 1.4% rise in March of 1980. The sharp rise in September followed increases of 0.5% in each of the prior two months, bringing the annual inflation rate for the quarter to 9.4%." (Dean Baker at CEPR)

However, if you look at the core inflation, without food or energy, it was just 0.1%, which is the same as it has been for the last five months. That means that the annual rate in the core inflation rate for the last quarter has been just 1.4%. But as we will show in a few paragraphs, that number doesn’t tell the whole story. If you take out the housing component of the core index, you find that inflation has been rising 2.2% over the last quarter.

But the government changed the way it calculates the housing portion of the CPI back in 1982. If you use the old method, you would find that inflation is 5.3% today and even core inflation is 4.3%. This is a far cry from 2.2%. Can you imagine the 10-year bond prices if inflation was thought to be 5.6%? Somewhere north of 7%, I would think, and certainly high enough to put more than a crimp in housing prices.

Inflation and Housing Costs: Shedding Light on the Confusion

If all of this sounds a bit confusing, that is because it is. Let’s see if we can shed some light on the process.

The government currently assumes that housing costs are 23.158% of the Consumer Price Index. Prior to 1982, the housing cost numbers were based upon what you actually spent for the house and the related mortgage. After 1982, the Bureau of Labor Statistics (BLS) began to use an imputed number. They now use what is known as "owners’ equivalent rent of primary residence" for the housing portion of the CPI. This is based on an economic theory that says that homeowners are essentially leasing the houses from themselves and paying implied rent for that service.

In theory, they are trying to figure out what it would cost you to rent your home. There’s actually a rational reason for doing this and we will talk about that in a minute, but first let’s look at the numbers.

Why are these imputed rents so low? Dean Baker tells us, "The main factor holding down shelter costs is the overbuilding associated with the housing bubble. This has led to record nationwide rental vacancy rates, which is putting downward pressure on rental prices in many of the areas with the biggest bubbles in housing prices. For example, rents in the New York City area rose by just 1.9 percent over the last year. They rose by 1.8 percent in Tampa, Florida and by just 0.3 percent in both Boston and San Francisco. (This is the inflation rate for the owners’ equivalent rent index, which strips out utility prices.)"

How much does using imputed rent affect the CPI? Bill King wrote a few months ago, "In the Q1 GDP data, the US government has housing prices up only 1.1%, yet industry data shows double digit gains. And this week the June existing home sales data shows a 14.7% increase in the median house price. The BLS has ‘owners’ equivalent rent of primary residence’ up only 2.2%.

"A couple of months ago, we delved into the BLS web site and discovered that "owners’ equivalent rent of primary residence" is also suppose to account for real estate tax hikes. The Rockefeller Institute has the average US real estate tax bill +6% y/y. Of course it’s double digits in most urban areas.

"Here’s the math: 14.7% + 6% = 20.7%. But the BLS calculates this at 2.2%. 20.7% minus 2.2% = 18.5%. Now multiple by 23.158% and you get 4.28%. So by this metric, CPI is understated and thus GDP overstated, by 4.28%."

Indlation and Housing Costs: Not Feeling Like a Recession

Remember that real GDP is calculated after inflation. You subtract the inflation rate from nominal GDP to get real GDP, which is the number everyone focuses on. So if inflation is higher than the BLS statistics show, which means GDP is not as high. The numbers have not changed all that much since the first quarter, so that would mean that GDP growth is almost non-existent if we used the old method of figuring housing costs.

If the CPI were 5.3%, we would be in a serious recession. But it doesn’t feel like a recession. Profits are rising, unemployment is falling and things seem to be moving along just fine, thank you. So what gives? Is there some government conspiracy to understate inflation, so that they don’t have to pay large increases in Social Security and other inflation indexed payments? The answer is – not really.

If you look at a graph of home ownership cost you find that the numbers are actually very volatile. And I mean very volatile. In 1985, prices were rising at 6%, and just two years later prices were falling by 6%, but one year later 1988 prices are rising over 8%. Dramatic swings of 4-5% over a period of a year are quite common.

If you look at a graph of owners’ equivalent rent you find that the volatility is much less and the moves take a longer time. Instead of 14 percentage points swings in just one year, you get 1-2%.

If you put these charts together, it almost looks like the imputed rent is an average mean of the actual costs. By that I mean that the actual costs swing both higher and lower, constantly reverting to the mean or long term average. Now that is not what it actually does from a calculation standpoint, but the chart sure looks that way.

In an odd sort of way, the imputed price seems to work rather well in smoothing the volatility. Otherwise we would have times when GDP said "recession" while the economy was growing and vice-versa. And this makes a certain sense.

Economists often claim that the CPI overstates inflation. And the housing component did do just that in the periods around 1987 (by 10% at one point!), from 1989 through 1994, briefly in 1996 and from 2001 through 2003.

But now, we are getting a rather large difference of almost 8% between actual costs and imputed rents! Looking back since 1982, this is the largest such difference of any one period.

Inflation and Housing Costs: Housing Prices Must Stop Growing

What does that tell us? If this is indeed a mean reversion effect, as the chart makes it look to be, then we would expect either rents to rise or housing prices to become stable or fall, and not too far into the near future.

But as noted above, we now have record nationwide rental vacancy rates. Such does not portend for a rise in rents, so we are left with the thought that housing prices must at least stop growing, if not fall somewhat. And we read in paper after paper that they seem to be doing just that.

Could it be that the Fed rate increases are having an effect? Today, if you decided to buy a home and planned to pay it off in a few years, you find that a 15-year loan is cheaper than a one-year ARM. In fact, you would pay 5.625% a year with perfect credit! That is a far cry from the lower than 2% ARM rates of just a few years ago. (I know, Bloomberg says rates are lower than that, but try and get one!)

Gone are the days of the cheap mortgage. In the United States, refinancing a home last year brought in an astonishing $600 billion – or about 5% of GDP. That is, people "made" more money from refinancing their houses than they gained from salary increases, investment returns or any other source.

As housing price gains slow and then maybe stop, as interest rates continue to rise, that "cheap" money from borrowing against your home is going the way of the dodo, at least for awhile.

So, which is it? Is inflation running at a 9.4% clip, a 5.6% rate of just over 2%? The correct answer is both. It just depends upon how you want to calculate the numbers and over what time period you want to calculate them.

But the various Fed governors seem to be calculating them using numbers, which suggest inflation. Bert Dohmen brought this quote from Fed Governor Richard Fisher of Dallas to my attention, "We cannot let the equivalent of sclerosis block the arteries and disrupt the workings" of the economy, Fisher said. "Nor can we let the inflation virus infect the blood supply and poison the system."

As a little side note, using BLS statistics, health care costs are about 17.5% of consumption, but it is weighted much less in the CPI calculation. Healthcare is 4.649% of CPI; healthcare commodities are 1.484% of CPI. Healthcare is reportedly 15 to 17% of GDP. This presents a huge discrepancy in CPI weighting. If CPI healthcare costs were in tune with reality AND they had an accurate weighting, CPI would be substantially greater. (Bill King)

BLS assumes health care costs have risen about 4% a year for the last ten years. Anyone who is paying health insurance knows this is not the case.


John Mauldin
for The Daily Reckoning

October 20, 2005

John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail Thoughts from the Frontline. As well as being a frequent contributor to The Daily Reckoning, Mr. Mauldin is the author of Bull’s Eye Investing (John Wiley & Sons), which is currently on The New York Times business best-seller list.

In his easy-to-read, straightforward style, Mauldin spots the big market trends – and shows you how to profit from them. Bull’s Eye Investing is a must-read road map if you want to avoid the pitfalls of the modern investing landscape…

The Bird Flu is still advancing from the East.

Hurricane Wilma is coming up from the South.

The real threat, Jeremiah warned the Israelites and the minister of St. Michael’s warned Londoners, is internal, not external.

But here…we give the devil his due. Events have a way of being linked together. One thing leads to another, and to another…where the chain leads, we cannot know. But sometimes it just seems to go bad.

King Edward III’s daughter died of plague in the 14th century. She was not the only one. The disease carried off the king of Castile, the queen of Aragon, the son of the emperor of Byzantium, the queen of France, and the queen of Navarre. Neither purple nor velvet were proof against the malady.

The archbishop of Canterbury died. Then, his successor died, and then his successor’s appointed successor died, too.

In some places, half the population was wiped out, with a third of the entire population from India to Iceland in their graves before the plague disappeared.

Where did the plague come from? It arrived with the great Mongol empire. In the battle for the Genoese port city of Kaffa (now Feodosia), the besieging Mongols had an idea; they would catapult the bodies of their own plague victims over the city walls. It took little time for the fleas on the infected bodies to jump to living bodies…and soon the town was sick. Those still healthy had had enough; they retreated in their galleys across the Black Sea back to their homeland, Genoa, and brought with them the cursed disease.

For many, death from the plague must have come as a blessed relief. Early in the 14th century, Europe suffered some of its worst weather, poorest harvests, and bloodiest uprisings in history. Violent storms hit the coasts and destroyed dikes. Cold, rainy summers ruined harvests. The price of food rose 500%. People ate cats, rats and even animal dung. When those delights ran out, they dug up the dead and ate them.

Those who did not starve to death or die of plague often died from violence. In 1303, the pope himself was captured by a mob. He died soon after under mysterious circumstances. The next pope was murdered. His successor removed the whole papal administration to France, to Avignon, where he thought he might be safe.

But there wasn’t much safety to be found anywhere. Peasant uprisings, the Hundred Years war, the Jacqueries, Guelphs vs. Ghibellines, bands of brigands roamed the country. "What shall they say that readeth this or heareth it read," asked the era’s leading historian, Froissart, "but that it was the work of the Devil?"

The devil works in strange ways: he causeth people to believe what they must believe when they must believe it. Thus is U.S. Treasury Secretary junketing around the world telling the poor benighted Chinese that they should take advantage of Wall Street’s "sophisticated" expertise? We don’t know…but we think he may be lobbing dead bodies over the city walls, trying to infect our rivals with the disease that has so weakened the Anglo-American economies.

Of course, few people on Wall Street or the U.S. Treasury department would agree with us. They claim there is some magic to shuffling money. The sophisticated dealers role up their sleeves, split the deck, mixed up the cards, and whammo bammo…there are twice as many of them! Here in London, we see the evidence of this expertise everywhere. The City, London’s equivalent of Wall Street, is the country’s most profitable industry. On both sides of the Atlantic, the masters of the universe seem to be holding the best cards. Just walk into a fancy restaurant without a reservation, or try crossing the street without looking both ways, and you will find yourself without a meal…or without a leg. Small comfort will be that you have saved yourself $500 or been run down by a Porsche. All this money must come from somewhere. But where? Are they really offering the world a ‘new deal’ based on sophisticated new knowledge that better allocates capital and increases everyone’s wealth? Is it another milestone on the road to progress, democracy and prosperity?

Or is it another devilish old false shuffle – loading up the world with debt while skimming the best cards for themselves?

We will see, dear reader, we will see.

More news from our comrades at The Rude Awakening…


Steve Sjuggerud, reporting from Florida:

"While real estate rises over the long run, there are distinct periods where it falls. In short, based on a Fed study, right now we are right at the point where home prices should turn over and head downward again."


Bill Bonner, back in London with even more views…

*** "The price of gold has really backed off this week, which is fine with me, as it gives the investors in our MarketSafe Gold CD a good entry point," says our pal over at EverBank, Chuck Butler.

"Keeping its head above that $470 level has been difficult for gold, but from my view in the cheap seats, it looks like it’s just biding its time, forming a strong base, before heading to $500."

*** Elizabeth was out last night, so we took the boys to Burger King for dinner.

"Mmmm…this is great," said Edward.

"Yeah," said Henry, "how come we never eat here?"

"Well, your mother doesn’t like it," was our weak reply.

"Why doesn’t she like it? We like it."

A pound is a dollar is a peso. The meal cost only about 10 pounds for the three of us, or nearly twice as much as the same meal in the United States, or six times as much as the same meal in Argentina.

On the other hand, the meal we had, with friends, the night before – in a fancy restaurant in South Kensington – cost 20 times as much. Was the previous night’s meal any tastier, we asked ourselves? No, not really. Was it more satisfying? No, not really. Was it more nutritious? We don’t know, probably not. No, it was none of those things. Instead, it was different; it was more sophisticated.

The conclusion we draw from this is that sophistication is merely a way of separating people from their money. Not that they aren’t grateful for it. A sophisticated car is one that costs more money and breaks down more often. A sophisticated wine is wine so expensive that you don’t want to open it; when you finally do pull the plug, you find that it has gone bad. A sophisticated art lover is one whose walls are covered with hideous mock-art. And a sophisticated reader is one who picks up dull books that have won literary prizes and pretends they are good. A sophisticated homeowner is one who has mortgaged 100% of a house he cannot really afford. In each case, the sophisticated player feels superior…he is, after all, more sophisticated! But what about a sophisticated investor?

We recall that Warren Buffett, the most successful investor who ever lived, is noticeably un-sophisticated. He does his calculations on a yellow pad, with a pencil. He operates on the basis of old fashioned, well-known principles. He does not use sophisticated strategies or sophisticated techniques. He merely buys good businesses, run by people he trusts, at prices he thinks reasonable.

Buffett is the second richest man in the world. Think how rich he would be if he used Wall Street’s sophisticated expertise! Won’t some enterprising stockbroker, maybe from Vancouver, give the poor man a call?

The Daily Reckoning