February 23 sees the release of US CPI and core CPI figures for January 2005.

Screwing the pooch. Not a pretty image. But, if you hold US sovereign debt or save in a US dollar denominated account, get used to Fido. If you haven't already.

Some US investors have long complained that the core CPI used by the Fed does not include energy or food costs. It's common on Earth to accept these two items as essential expenses. Why those from Planet Fed fix on a "core" rate excluding food and energy is one of the mysteries of the cosmos.

The result is that the Fed gets ownership of a 2.2% core CPI rate as of December 2004 (it is thought they target 2%) and disowns, or so it appears, the broader CPI rate of 3.3% (also a December number).

But even the trim, slim "core" CPI understates inflation. In fact, both CPI rates do because of the way they tackle housing costs. In the CPI computation there is a small part of housing cost which is considered pure rental; and then there is, debatably, a much larger part called "owners' equivalent rent".

I'm not a statistician. Nor do I portray one on television. But I believe if something is labeled "owners' equivalent rent" it is not measuring mortgage costs. Convenient since rents have probably not risen anything like as much as house prices and their associated mortgage costs. Or at least that is my intuitive assumption given that the latest data shows an average annual house price increase of 13%.

Factor in, too, the effect of the "hedonic" adjustment made to CPI. I thank my UK writing partner for pointing this out to me via this article about relative US and European GDP growth rates. Whether it adds as much to CPI as the point-and-a-half cited is not agreed. But speakers of econometrics do seem to agree that it adds something.

All in all, significantly understating both its CPI measures might have been a brilliant and (if deliberate) devious way for the Fed to try claw back the budget deficit: just let inflation eat away at the debt. Unfortunately (but small wonder) ordinary citizens saw through and admired the scheme so much they emulated it. And, lo, there were twin deficits.

Well, I simplify. But if you're a saver and/or debt holder, it bites all the same.

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3 comments

  1. David Foster // 9/14/2006 06:18:00 PM

    I agree with you that the CPI probably understates the "true" rate of inflation. But it's not obvious how one *should* measure housing costs...if a person has a fixed-rate mortgage, their costs do not go up even if the value of their house goes up 13%....I assume that issues of this kind are probably behind the "imputed rent" method...

  2. cb // 9/14/2006 06:20:00 PM

    The reason it's not in there is because house prices are considered an asset, thus it's not a consumer price. The fed is very aware of asset valuations. Whether or not people are getting 'screwed' because cpi adjustments don't reflect that is debatable. And besides, disposable income (net of monthly housing costs) is going up much faster than cpi.


    cbyrne@capitalfixedincome.com

  3. RJH Adams // 9/14/2006 06:20:00 PM

    Hi CB.

    Thanks for the message.

    When savers have to go to a 3 year CD (3.43%) to just beat inflation they are doing the pooch. The BLS' own data (3.3% non-core) shows this, before discussion of CPI adjustments and/or mortgage costs. There is little incentive to save.

    The flow-of-services CPI approach which excludes mortgage costs was adopted by the BLS in 1983. Before that they were content with the asset-pricing approach (of course including mortgage costs). But either way, real transaction costs (and that's what a mortgage cost is) are what a decent inflation measure is meant to capture.

    I hear the argument that a house is an asset. So's a car (just ask the repo companies) and so is education. Who really wants to exclude these, too, from a real inflation gauge?

    Finally, and I hope I'm not misrepresenting your position, but I'm not sure why in the current context disposable income outstripping CPI would be good news for savers, inflation or, given your email tag, fixed-income investors.

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