Tuesday, June 19, 2007

Inflation Tamed or Skewed?

“Household surveys conducted in April indicated that the median expectation for year-ahead inflation had moved up, consistent with the recent pickup in headline CPI inflation.”
FOMC Minutes – released May 30th, 2007

“Core inflation remains somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.”
FOMC Statement – released May 9th, 2007

These are the two main statements from the Federal Open Market Committee’s (FOMC) May minutes and statement highlighting inflation concerns. While reading these two statements, it seems as if the Federal Reserve continues its hawkish tone on inflation. However, just last week we received two more pieces of inflation data that will help fill in the puzzle for the FOMC at its next meeting on June 27-28. The numbers in May were more or less in line with estimates (see below) and the bulls embraced the numbers with more than a 1.5% gain throughout the week in all major U.S. indices. The headline number came in at +0.7%, slightly hotter than the expected 0.6% while the core CPI number came in at +0.1%, below the expected +0.2%. But does that mean inflation is tame, or is there a hidden story within the numbers?

If you have read some of my past posts, you understand that I am not a fan of the Bureau of Labor Statistics’ (BLS) methodology for calculating inflation. They completely overlook food and energy prices which can eventually affect monetary policy decisions. Before I jump completely off the topic and into the BLS’ methodology on owner equivalent rents (OER), let me discuss the omitted energy prices and their affect on the consumer’s pocketbook.

Financial media has been coat-tailing the fact that higher oil prices translate into higher gas prices and less disposable income being spent by consumers in other places such as retail. Although it could be argued that higher oil does not necessarily translate into higher gas prices, we will leave that up to energy traders. Consumer spending has continued to support the market to record levels because, well, consumers continue to spend in the face of higher gas prices. How you might ask?

First, let me remind the readers that as long as the consumer can withstand an increase in energy prices because of an increase in income, it should not hinder the consumer’s spending habits. In reality, the consumer has not felt the increase because they are taking home more income. According to Miller-Tabek research, personal income has been rising at an annual 6% rate or 0.7% more than the 15 year average. If we have above average income, there is a good chance the consumer will go ahead and spend instead of save, but can that 0.7% pay for an ever increasing energy bill? The answer is undoubtedly yes! Let’s see what Miller-Tabek has to say:

“The income numbers have simply overwhelmed, providing the best explanation for the resilience in consumer spending in the face of high energy costs. Incomes have increased $1.7 trillion over the past three years to $11.4 trillion, plenty to handle the extra $50 billion to $80 billion of added expense each year. Interesting also is the fact that the price of oil remains below its peak and hasn't really changed much since Katrina over 20 months ago. Since that time households have seen their incomes growth $1.3 trillion.”

So when discussing higher oil prices, let’s also mention income growth and whether or not the consumer will be able to withstand the increase with their income. The outlook for future income growth will most likely be less than the past three years, so keep an eye on income growth over the next few quarters. Currently, the consumer is still able to foot the bill and high oil prices should not be the media’s escape goat for the market not pressing higher.

Apparently, the markets now believe inflation is contained. Of course, as I mentioned above this ignores both food and energy prices. However, there are some other slick calculations made by the BLS to complain about. The biggest of those is about the BLS’ methodology in calculating OER which enables them to make higher inflation look like lower inflation. I have to give credit to http://www.bigpicture.typepad.com/ for discussing this in their blog.

First of all, why does OER even matter? Well, housing accounts for 42% of the CPI, which is then broken down even further where OER accounts for 23% (see table below). Therefore, OER should not be taken lightly. Here is a short description of the BLS’ methodology:

“The economic rent is the contract rent (including the value of certain rent reductions) adjusted by the value of any changes in the services the landlord provides. A change in what renters get for their rents is considered to be a quality change, which may be either positive or negative. The value of any changes is applied to the current economic rent to make it consistent with the previous data. For example, adjustments are made for most changes in utilities and facilities.”

Essentially, they net out utility payment so if the rent stays constant and utility payments go up; the OER actually drops. So not only does the core CPI remove food and energy prices from their calculation, but they alter the true price of OER due to netting out utility payments (which have been increasing over the past few years). Talk about creative accounting, this is creative deception. Economists are a slick group of people. Argue with a good economist and they could probably show you that we are in a recession at the same time the same economist argues for steady growth.

Sources: Bureau of Labor Statistics, Miller-Tabek research, Briefing.com, BigPicture.blogspot.com

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