On inflation again, core and otherwise (and my learning curve)

Discussing inflation with a colleague today. His argument was that core or non-core inflation are short-term considerations: in the long run, they bring one to – more or less – the same point. To the internet!

Sifting around, I found quite a bit of interesting information at the Cleveland Federal Reserve (and, can I say, I would find things less confusing still if there were just one of these things? It’s the Federal Reserve, not the Supreme Court).

There, they tell me that there exist 3 main CPI measures:

  1. CPI for all urban consumers (CPI-U). This is the most frequently reported statistic in the media. It is based on the buying habits of the residents of urban or metropolitan areas in the United States, a segment of the population which accounts for about 87 percent of the U.S. population.
  2. Chained CPI for all urban consumers (C-CPI-U). This index applies to the same target population as the CPI-U. The same raw data are used, but a different formula is employed to calculate average prices. The chained CPI was developed to overcome a shortcoming of the CPI-U series, which does not account for the changes that people make in the composition of goods that they purchase over time, often in response to price changes. The alternative method of the C-CPI-U is intended to capture consumers’ behavior as they respond to relative price changes.
  3. CPI for urban wage earners and clerical workers (CPI-W). This is a subset of the CPI-U group and represents about 32 percent of the total U.S. population.

This was, as I understood it, his argument. They all include much the same things, including food, transportation and housing. My problem kicked in a little further down that same page.

In North America, the major measures of core inflation are:

  1. CPI excluding food and energy. The most commonly used measure of core inflation is the CPI excluding food and energy, published by the BLS. [The term “core CPI” is often used to refer to this measure.] This measure of core inflation systematically excludes food and energy prices because, historically, they have been highly volatile. More specifically, food and energy prices are widely thought to be subject to large changes that often fail to persist and frequently represent relative price changes. In many instances, large movements in food and energy prices arise because of supply disruptions such as drought or OPEC-led cutbacks in production. [You can find core CPI data for the United States here.]
  2. Trimmed mean. The trimmed mean removes from overall CPI inflation all large relative price changes in each month, with the set of excluded components changing from month to month. In particular, the trimmed mean excludes the percent changes in price that rank among the smallest or largest (in numerical terms) changes for the month. Both small and large percent changes represent large price movements relative to the average for the month. The rationale for the trimmed mean is partly statistical, … [partly] economic. [You can find trimmed mean CPI data for the United States here.]
  3. Median CPI. The median CPI trims all but the midpoint of the distribution of price changes. If, for example, the overall price index included 100 components with equal relative importance, the median CPI would simply be the 50th largest percent change in price. The statistical and economic rationale for the median CPI is the same as for the trimmed mean. [You can find median CPI data for the United States here.]
  4. CPI excluding energy. Although not commonly used as a measure of core inflation, a potentially useful alternative to the CPI ex food and energy is the CPI excluding just energy. Also published by the BLS, this core indicator excludes energy prices for the same reasons the CPI ex food and energy does. But food prices—which include prices of food away from home and prices of food at home—remain in the index, on two grounds. First, the rate of change in the cost of food away from home is very stable. As a result, the food away from home component of the CPI is unlikely to be subject to large relative price changes and may well be persistent enough to have important predictive power for future inflation. Second, the food at home component has become a less important source of volatility in the CPI. The relative importance of food at home—in effect, the weight of food at home in the CPI—has declined sharply, from 17.8 percent in December 1967 to 9.6 percent in December 2000. As a result, a large change in food-at-home prices affects overall CPI inflation much less today than it would have 30 years ago. Moreover, the variability of food-at-home prices has declined over time, even abstracting from the unusual inflation developments of the early 1970s through the early 1980s.
  5. CPI excluding 8 components. Even if the overall food and energy price components of the CPI are viewed as being highly volatile, some specific food and energy items are much less variable than others, while some nonfood and nonenergy prices are highly volatile. Within energy, the volatilities of fuel oil and motor fuel far exceed the volatility of natural gas and electricity…. Similarly, prices of fruits and vegetables vary much more over time than do prices of dairy products or cereals and bakery products. At the same time, infants’ and toddlers’ apparel, public transportation, and used cars are some of the most volatile components of the CPI.

Which was my point, at least originally. Comparing these, and in accordance with the original argument of my colleague, we get the non-core and core CPIs, as defined above:

fed 1

We can also throw all of these “core”-ish measures in:

fed cpi 2

We still do not get a hell of a lot of difference. Which is to say, my colleague has brought me to a level of understanding that I would not have reached without him, and I’m grateful.

Moving on.

Like all good discussions, ours evolved. My colleague argued the problem that he saw with CPI – new goods and services. We already know that a limit to the CPI is that the “basket” changes in composition, over time. My colleague was discussing the health/medical services sector (where much of the new goods and services are to be found, and where, naturally, much of the inflation is also to be found):

inflation bls

Food isn’t in there (in the sense that its inflation is not as will be measured for this quarter) – crop yields, etc. are a mite too recent. Look out for the next quarter or too, though. Should be interesting.

My colleague was arguing that the link between these (and other) appreciating prices and relative factor prices (i.e. incomes) is tenuous. Median incomes have not moved, much, in a good long while: if one compares (as the financial help centre .com does) median incomes:

http://www.thefinancialhelpcenter.com

with median incomes divided by the CPI (i.e., real median incomes)

http://www.thefinancialhelpcenter.com

Etc. Interestingly, they also divide median incomes by gold:

http://www.thefinancialhelpcenter.com

Not unlike I attempted to do here. Their conclusions mirror those of my colleague – that the middle lump of households in America have gone nowhere, for all our talk of prosperity; they also mirror my secondary argument: that it’s all a recipe for depreciating US dollar-values. Our new, accidental, third party is rather more politically cynical, on this score:

From a long-term perspective, it clearly shows that the Federal Reserve, and the Federal Government have a long-standing policy to devalue the Dollar for their own political purposes, and financial advantage. This means that even though we are living in a world that has brought us untold riches, advantages, and comforts, through the advances in technology, since the 1960’s; when it comes to paying our bills, for the necessities of life, like food, shelter, and energy; we have a more difficult time doing so today, than we did from 1965 to 1971, when our Median Income would buy about 200 ounces of gold! Even at the recent peak, in 2001, Median income would only buy 155 ounces of gold, and in 2006 it was down to 76 ounces!

The policy that was used to lower our standard of living, for the last 36 years, has separated Americans into two dominant groups. One group has continued to tighten their belts, and do with less, just to try to stay even in this quicksand. By being frugal, some have been able to save and invest a little of their earnings. By investing in inflating assets, their net worth has grown.

As I said in that last post about this, if there’s a criterion for calling growth in GDP, real or nominal, growth in wealth, median incomes (real or nominal) have to move. Flat real median household income for 10 to 30 years does not equal “getting richer”. It equals “having to paddle harder to stay afloat”. Who knows? Perhaps the Bank of Japan was onto something over my head, all along.

Finally, going outwards, as they say: I don’t believe this idea of excluding food and/or energy prices is going to work for long. I say this as a subscriber to Peak Oil, Peak Food, Peak Anything-We-Get-Out-Of-The-Planet: such factors are volatile components in CPI, but they trend upwards and will (a) probably be less volatile, and (b) probably trend upwards more steadily.

I could be wrong: OPEC may have been sitting on all the oil that they claimed all along. Australia’s crop yields may recover, as may Europe’s. Storms may stop bashing the hell out of capacity in the US and Mexico. The future long-run CPI’s may match all the previous long-run CPI’s perfectly, and in a year or two we could all lose our jobs over the way we’ve been acting. I just don’t believe that will be the case (though I shall be glad if it is – I can always find another job).

Returning to the original argument, though. I like to think I have a better working understanding of inflation – enough to realise that my perspective needs to be longer, in order to understand policy (this comes with being young – my colleague is not old, by any definition, but he is a good deal more learned and wise). I still think the policy is wrong, of course – but we may see it evolve, slowly (once we get this skating-close-to-recession business out of the way).

Finally, although he doesn’t read this, I hope I’ve correctly presented every other person’s arguments, here. Always remember this: never take any person’s version of the words of a third person as verbatim. It almost never will be.

Extra Credit. Related to this idea that altering our working values for CPI would wipe out all the real gains in GDP over the last decade, the blog The Big Picture was asking this morning what effect this new season of write-downs by big banks would have. To wit:

Merrill Lynch (MER) just wrote down $8 billion dollars, erasing 5 years of profits. Citigroup (C) dinged $11 billion. Washington Mutual, (WAMU) Countrywide Financial (CFC), Bear Stearns, GMAC – there seems to be an ongoing parade of mea culpas that are erasing not just quarters of profits, but years of earnings. And there are likely to be many more of these, as tier 3 assets get priced appropriately.

What’s truly astounding is that we may only be seeing the tip of the iceberg. Its possible that the big brokers and banks have $1 trillion in toxic debt on their books to be written down. That would equal decades – not years – of profits to be wiped out.

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1 comment so far

  1. JB on

    You make some very cogent points, but there is no need to overstate the impact of inflation to make the case that it is destructive. A question you need to ask and answer before making any quantitative conclusions is: what has happened to the average size of households during the past 40 years?


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