Eyeballing Low-Ball Inflation Numbers
By Peter Eavis
Senior Columnist
12/24/2003 07:31 AM EST
thestreet.com
Of all the economic numbers that drive the market, the inflation rate is among the most avidly watched. But recent data strongly suggest that the government's consumer price index is understating how quickly prices are rising, according to two economists.
Having a faulty CPI for the economy is like having a faulty speedometer on a car -- it makes it hard to know how firmly to press on the accelerator. In the case of the economy, that accelerator is the level of interest rates -- which the nation's central bank, the Federal Reserve, heavily influences through its federal funds rate.
Investors place many of their bets in financial markets on the basis of what they think the Fed is doing with interest rates, and that means they closely watch the sort of economic statistics -- such as inflation -- that might cause the central bank to change its rate policy. Since President Nixon yanked the dollar off a gold-based currency system in the early '70s, inflation, which tends to go up when central banks allow money supply to grow strongly for too long, has been rampant in the world economy. When inflation rises too fast, central banks have to hoist interest rates to prevent severe disruption to the economy, but hiking rates can also cause recessions.
To be sure, inflation has been low in recent years in the U.S. But growth in credit and, till recently, money supply has been very strong, leading a small minority of economists to fear that inflation could pick up more quickly than the Fed expects. If the Fed were to be caught off guard, it may have to raise rates aggressively, which would roil stock and bond markets. The chances of the Fed doing that are higher if the CPI is understating inflation. While the central bank does not set policy on the basis of one or two data points, it has frequently communicated that it believes inflation not to be a threat to the economy. Until recently, the Fed was far more worried about the threat of deflation.
So what is the evidence for a broken CPI? Some economists have long believed that inflation in the real economy is not being captured in government numbers. Suspicions intensified after the release of the November CPI, which rose by 1.8% from the year-ago period -- far less than most economists expected. The index showed that prices were decelerating in sectors of the economy that are clearly showing inflation -- such as medical costs and education. Apparel prices also fell, despite steep recent increases in the prices of cotton and oil, notes John Vail, a strategist with Mizuho Securities.
What's causing Vail as well as Paul Kasriel, an economist at Northern Trust, to scratch their heads is the disconnect between the producer price index and the CPI. The PPI, which measures wholesale prices, has been moving up very strongly in recent months, and such a rise usually translates very quickly into an increase in the CPI.
"I don't have a lot of faith in government statistics in general," says Kasriel. "But I find this divergence between the PPI and the CPI very strange."
Soaring commodity prices have pushed up the PPI. Kasriel also thinks that the plunging dollar should have led to upward pressure on inflation in the U.S. (imported goods rise in price in dollar terms when the currency is falling). Kasriel points out that the European countries that use the euro have a higher inflation rate, even though their currency is stronger.
Indeed, Vail estimates that the CPI would have risen in November at a year-on-year rate of 3.4% if the CPI had maintained a close relationship with the PPI. That is way higher than the 1.8% reported by the BLS -- and it should cause investors to think hard about what's happening.
One possibility is that the retailers are "eating" the rise in wholesale prices themselves, and not passing it on to consumers. That doesn't seem to be the case, says Vail, since there hasn't been any economic evidence of a big squeeze in retailers' profit margins.
Alternatively, the CPI may just be showing price increases at more of a lag than in the past. But that is hardly comforting, because it means it will start rising sharply in the future.
Would higher prices lead to higher rates even if the inflation isn't showing up properly? You bet. Here's what would happen. Consumers would borrow more to pay for the higher-priced goods, which would push up demand for credit and put upward pressure on the market price of credit, which is simply the interest rate on loans. The Fed would then have to decide whether to hold rates down by supplying more reserves to the banking system.
It pays in confusing times like these to look at what the markets are thinking about inflation. The bond market doesn't seem overly concerned. And it may be taking its cue from the fact that money-supply growth figures have slowed markedly. But strength in bonds may just be due to money flows related to the weak dollar. One would think that a weak dollar would lead to weakness in U.S. government bonds. However, foreigners may think U.S. bonds look more attractive in terms of their own currencies the more the dollar falls.
On the other hand, gold, the classic inflation hedge, has rallied strongly in 2003, signaling that investors in the metal could be afraid of resurgent inflation. Or they may be buying the asset because they think the global financial system, bloated with dollars after years of Fed largesse, is so sick that it could break down soon, leaving only gold as a dependable store of value. |
