What is ‘real’ inflation?

By Ben Turney.

The threat of inflation is a regular theme here at Spreadbet Magazine.

We are deeply concerned about the long term implications of the excessive easy money policies of the major central banks, since 2008. In the absence of clearly defined exit strategies, the likelihood is that once this money starts seeping out into the real economy, prices will head much higher. Financial markets have already experienced the super-charged effects off this.

A crucial point, which has been missed in the current debate about tapering, is that the taper is not an exit strategy. It will simply be a reduction of the Fed’s extraordinary bond purchasing programme. They will continue to purchase billions of dollars of financial assets each month, to add to the $3.73trillion in “assets” it already holds. The explosion in the sheer size of the Fed’s balance sheet is already troubling in itself, but the greater it grows the greater the hazard posed by future inflation.

If you follow the comments of mainstream economists, their mantra is “fix the problems of today, postpone the problems of tomorrow”.

Leaving to one side the staggering short-sightedness of this approach, what very few policy makers seem to care about is the increasingly detrimental effect inflation is having on people’s daily lives now.

Sadly we live in era of fudged statistics and obfuscated reporting. Every effort is made to preserve fragile confidence at the expense of facing up to the reality of the decisions facing us all. When it comes to the discrepancies in GDP data or the manipulation of unemployment figures, this matters unyet it tends not to cause much of an outcry. After all, these numbers don’t have much bearing on people’s daily lives. For the most part they pay little to no attention to them, that is if they are even aware they exist!

Inflation, on the other hand, is a very different beast; a very different beast indeed.

Below is a 7 year chart of official US CPI, which I’ve used in next month’s magazine:

 It looks benign enough and has been used to justify Fed policy over the last 5 years.

However, there are significant problems with the manner in which CPI is calculated. You can read more about the calculation here on the Fed’s website, but the key quote is;

“Although food and energy make up an important part of the budget for most households—and policymakers ultimately seek to stabilize overall consumer prices—core inflation measures that leave out items with volatile prices can be useful in assessing inflation trends.”

I don’t like accusing central bankers of being stupid. No matter what anyone says, they’re not. These are incredibly intelligent people. Even so, the method for calculating CPI feels very much like a fix. It is true that this predates the financial crisis, but this calculation very conveniently ignores the substantial increase in commodity prices, since the start of the decade. This has been directly caused by “accommodative” monetary policies. When Greenspan first opened the tap, post-dotcom, this started an almost uninterrupted flow of liquidity, which has culminated in the Fed now owning $3.73trillion of financial assets. Forgive the repetition of that figure, but it merits it!

So what is the upshot of all this?

Well take a look at the table below. Taken from www.quandl.com (which is fast becoming by favourite research tool!!!), this highlights the discrepancy between the official CPI figures and real world price increases. At the bottom, note the growth (or lack of it) in median incomes for the lowest quintile:

So Mr Bernanke, it is all well and good fudging the official inflation rate and then using this to justify your policies, but if you’re not careful these decisions are going to cause severe social unrest. This is not being alarmist. It is a simple observation of human behaviour. The harder it is for people to get by the more aggressive they become. So far, we haven’t witnessed any severe social unrest as a result of the financial crisis. It has certainly been nothing like the 1930s or even 1970s, but the trend of events is heading in one direction.

And that is not taking us to a happy place.