New Inflation versus Old Inflation

| March 19, 2011

The Consumer Price Index is tracked by the Federal government and intended to provide a measure of price inflation as experienced by the consumer. According to the long-term trend in the CPI, the consumer has experienced relative price stability following the highly inflationary period during the 1970s. However, the methodology used to calculate the CPI has changed dramatically since 1980, and if you compare the old CPI with the current CPI, a striking divergence is observed during the past 30 years as shown on the following graph from Shadow Government Statistics (SGS).

According to the traditional methodology, consumer inflation has been rising dramatically during recent years and even spiked well above 10% heading into the 2008 recession. Of course, the Bureau of Labor Statistics claims that the methodology changes have improved the CPI, causing it to provide a more accurate reading. However, many experts disagree with that assertion, including economist John Williams of SGS. Was the old methodology grossly overstating consumer inflation, or is the new one grossly understating it? Perhaps the world has changed meaningfully during the past 30 years and the new CPI better reflects this new inflationary paradigm? As Dow theorists, we prefer to interpret and align ourselves with market behavior, and inflation sensitive markets such as gold, oil and commodities have communicated an unambiguous message during the last decade with respect to inflationary pressures.

Regardless of whether the current CPI accurately reflects inflation experienced by the consumer or understates it, there has been a material increase in the reported data during the past few months. In his weekly commentary, John Mauldin reviews the latest readings along with the reemergence of a troubling trend in real wages.

The guy on the street is getting squeezed. Real US consumer spending slowed in January and looks like it did only marginally better in February. The Fed argues that inflation is mild, as they prefer to look at “core” inflation (inflation without considering food and energy). If you look at it that way, they are right. And in normal times, I can kind of see why we strip out energy and food, as they are very volatile price points and can move a lot from month to month. But that argument gets a lot weaker when your main policy, that of significant quantitative easing, is perhaps CAUSING the rise in food and energy (as well as weakening the dollar)! If the Fed policy is at least contributing to the cause of total inflation, arguing that food and energy don’t count doesn’t hold water. Let’s look at the following chart from
In particular, notice the rise in the last three months since the beginning of QE2. Inflation is running at over 5% on an annualized basis. Companies like Kimberly (diapers, etc.), Colgate, P&G, and others all announced 5-7% price increases this week. These are companies that provide staples we all buy. Those prices matter. Even Wal-Mart will have to pass those increases on. To say that food and energy don’t matter misses the point. These items have real economic impact.

As my friend David Rosenberg wrote this morning: “In February, there was no inflation at all in average weekly wage-based earnings but there was 0.5% inflation in consumer prices, meaning that real work-related income was crushed 0.5% and has now deflated in each of the past four months and in five of the past six months, during which it has contracted at a 2.3% annual rate. Once the effects of fiscal stimuli wear off, this negative income trend will show through in a much more visible slowing in real consumer spending that we doubt the markets have fully discounted. So far, what has happened in equities has been treated as a financial event – just wait until the economic event follows suit. And it’s not only fiscal stimulus that is soon to subside. We still have that 86% correlation over the past two years between movements in the Fed balance sheet and the direction of the S&P 500 – this too will come home to roost before long, whether or not we end up seeing a resolution to the crises in Japan, Libya or Bahrain.” He goes on to give us this chart:
How’s that QE2 thingy working for you, Mr./Ms. Average Worker? Prices up, income down? And remember, most workers got the equivalent of a 2% pay hike with the temporary boost in Social Security, which goes away at the end of the year (and without which the economy and consumer spending would be even worse!).

Looking ahead, what happens if the tepid economic recovery fails to gain strength or, even worse, begins to exhibit signs of renewed weakness as we approach the end of the QE2 program? Does the Federal Reserve dare engage in QE3 with inflationary pressures beginning to emerge in the monthly data? We will see.

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Category: Commentary, Market Update

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