BLS’ calculation of CPI today is once again giving investors a misleading “all clear” signal..
The following is a guest post by George Schultze, founder of Schultze Asset Management LLC, an alternative investments firm founded in 1998 that manages approximately $230 million in assets and specializes in distressed securities. Mr. Schultze is author of The Art of Vulture Investing: Adventures in Distressed Securities Management (Wiley Finance, 2012).
We may never see inflation again if we only rely on the consumer price index, or CPI.
Sound extreme? Consider this, then: The largest component of CPI is gathered by asking homeowners how much rent they'd charge if they were to rent their homes today.
Here's some background. Most market participants need to keep apprised of inflation because it’s a key variable used as an input for calculating the value of nearly every asset. Inflation is defined as a rise in the general level of prices of goods and services in an economy over a given period. In the U.S., the most commonly used statistic for measuring inflation is the consumer price index (“CPI”). CPI is calculated by the U.S. Bureau of Labor Statistics (BLS) and is intended to measure “the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services” according to BLS’ website.
Inflation, as measured by the CPI, has been quite benign lately (1.4%) and is generally below the U.S. Federal Reserve Bank’s (the “Fed’s”) target rate of 2.0%. This rate has helped justify an unprecedented amount of monetary accommodation recently by the Fed. However, one major problem with CPI is that a significant driver of its calculation (as a result of “owner’s equivalent rent”) is itself driven by short-term interest rates. As such, CPI unfortunately creates a negative feedback loop, between the Fed’s policies and CPI, whereby lower interest rates cause lower CPI figures which, in turn, lead to lower rates.
The largest component (approximately 33%) of CPI is the overall cost of shelter. Most of that number is determined by something that the BLS calls “owner’s equivalent rent”. A long time ago (before the early 1980’s), BLS used actual market-based sales prices for houses to measure actual changes in the costs of housing to calculate CPI. However, because this method led to “inappropriate results for goods…purchased largely for investment”, BLS decided to implement a new “rental equivalence approach” starting in 1983. The “corrected” approach measures changes in price of shelter through statistical survey data compiled by asking surveyed homeowners what rents they’d charge if they hypothetically rented their homes to someone else. This data is supplemented by asking the same homeowners about their monthly costs of maintaining a mortgage on their residence.
The problem with this hypothetical approach to measuring a significant portion of CPI is obvious at best. At worst, it’s somewhat disturbing in today’s information age where actual home price data are readily-available at the mere stroke of a key. The “corrected” CPI measure clearly failed to predict an incredible amount of home price inflation which ultimately led to the biggest housing bubble in the history of the world. After the housing bubble finally burst in 2008, the ensuing systemic risk that followed caused worldwide market tremors. With its methodology unchanged since then, BLS’ calculation of CPI today is once again giving investors an “all clear” sign. CPI of only 1.4% in May 2013 in effect waives a brightly-checkered flag to the Fed indicating that Bernanke may press the accelerator petal all the way down to the floor to steer our lackluster economy into overdrive.
Unsurprisingly, low U.S. interest rates have the effect of lowering the cost of housing for most surveyed consumers who depend on mortgages to finance their home ownership. As a result, with each push downward in short-term interest rates by the Fed, the cost of housing has literally gone down in lockstep – since most monthly mortgage payments are either adjustable or can otherwise be locked-in at lower rates with each downward interest rate movement. As such, a perverse negative feedback loop begins – the Fed lowers interest rates since unemployment is high while CPI remains low, the lower rates cause mortgages to be cheaper (at least temporarily), cheaper mortgages cause “owner equivalent rents” (the biggest component in CPI) to go down, so the Fed feels empowered to keep interest rates low. You can see where this is all going--we may never see inflation again if we only rely on CPI.
If I’m right, we may eventually see an ugly reset in the marketplace once investors start to focus on the weaknesses inherent in CPI as a measure of inflation. Meantime, let’s not get carried away with talk of a low CPI and let’s give it the attention it deserves – as a hypothetical measure of what surveyed consumers believe.
