Can We Measure Inflation?
The real investment geeks among us want 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 Consumer Price Index is the change in home prices. How are they measured? Ha! Trick question! Turns out homeownership is not included at all in the CPI. The Bureau of Labor Statistics considers owning a home to be a capital investment like stocks and bonds, so no home price changes are in the index. Instead, the bureau measures 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 the rents are doing.
In fact, 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 nonexistent 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. None of that showed up in the CPI, which was reported by the Bureau of Labor Statistics as 3.4% in 2005, 3.2% in 2006 and 2.9% in 2007.
There’s a deeper challenge when we realize each person and each region has its 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 affected by things such as educational expenses, medical expenses or costs for childcare.
Basing monetary and fiscal policy, not to mention the cost-of-living adjustment 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 to 50 years past, 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 increase of, say, 2% will mathematically reduce asset prices much more than in the distant past.
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 Statistics are seriously misguided about important aspects of “inflation,” then what is the right answer?
Sadly, we don’t presume to know. The big argument today is whether the large burst of “inflation” in 2021 is “transitory.” We would lean to “transitory,” but with a very low confidence level. Even there, what is the proper definition of transitory? Six months? One year? Three years?
We do, however, feel confident in saying that the Federal Reserve Board, which bases its policy decisions on a very tenuous balance between employment and “inflation,” has made and will again make major policy errors by relying heavily on “inflation” numbers as calculated. The concept of “inflation targeting,” whereby the Fed can maneuver inflation to a certain level and then stop it right there, strikes us as full of hubris and quite dangerous. Be on the lookout for potential mistakes that may result from inflation targeting overconfidence.
If nothing else, we hope that the next time you hear a chattering head talk about “inflation,” your new immediate response is: “It’s just not that simple!”
Jay M. Weinstein, CFA, is a managing director at Wealthspire Advisors.