So, we are skeptical of the blithe notion, subscribed to by the Federal Reserve Board and most of Wall Street, that they understand the causes of inflation and can nudge them in a certain direction with a little interest rate change here and a little stimulus there. The current idea that we “need” to generate 2% inflation and that we can just put the brakes on the economy at that point strikes us as being arrogant folly.

Can We Measure Inflation?
For the investment geeks among us, the rubber really hits the road in doing a deep dive into just how the government weights and measures price changes for people in the real world. Our conclusion is that you can’t do it in any way that makes sense and helps with policy decisions, and by ascribing false accuracy to your methodology, you end up doing more harm than good.

By far the most problematic and largest component of the CPI is how should we measure home prices change? Hah, trick question! Turns out home ownership is not included at all in the CPI. The BLS considers owning a home to be a capital investment like stock and bonds, and as such, no home price changes are in the index. What they do measure is rents, using a concept called owner’s equivalent rent. If you think about it, measuring home price changes is extremely difficult, but rents tend to reset annually for essentially the same product, giving many data points and a pretty reasonable approximation of what rents are doing.

Truthfully, using rents as a proxy for home prices worked quite well until the mid-2000s. But what happens when we have home prices booming or busting while rents don’t change or even move in the opposite direction? Now we have a serious measurement problem that creates a statistic in sharp contrast to reality.

That had never happened before the mid-2000s housing boom, but suddenly because of non-existent underwriting standards and low interest rates, home speculation zoomed out of control and price gains in many markets were annualizing at a double-digit pace. But none of that showed up in the CPI, which is reported as 3.4% in 2005, 3.2% in 2006, and 2.9% in 2007 (Source: U.S. Bureau of Labor Statistics).

The challenge becomes even deeper when we realize each person and each region has their own individual inflation rate, which probably can’t be calculated anyway. We all have a set of shared expenditures (food, clothing, shelter), but each of us will be in a different life stage at any given moment and will be more or less impacted by things such as educational expenses, medical expenses and/or costs for childcare.

Basing monetary and fiscal policy, not to mention the cost-of-living adjustment (“COLA”) for Social Security recipients, on such data is not likely to end well.

So Why Are We Terrified of Inflation?
Even though it’s now 40-50 years ago, the inflation and stagflation of the 1970s left scars on the psyche of market participants and policy makers that still exist. While inflation is very hard to measure, there’s no doubt that a general sustained rise in prices will increase overall interest rates. Since all financial and real estate assets are valued with some sort of interest rate discounting mechanism, higher rates will cause lower prices. Also, because we are starting from historically low levels, an absolute interest rate rise of say, 2%, will mathematically reduce asset prices much more than in the distant past.

Conclusion
As noted, the topic of inflation proved to be so thorny that we are covered with band-aids in attempting to summarize it. It really is the classic rabbit hole, where you start in one direction and end up lost in a totally different one.

So, if we think that Keynes, Friedman, Buffett and the Bureau of Labor Studies are seriously misguided about important aspects of “inflation,” then what is the right answer?