Is Inflation Actually Low?

Every month, the Federal Reserve Bank of Cleveland reports the latest consumer price index (CPI) numbers, including the median CPI. The numbers were recently released for May 2016.

The CPI was up 0.2% in May. Over the last 12 months, it is up just 1%.

These are the numbers we typically hear reported. If you take that number alone, then consumer price inflation is below the Fed’s 2% target. Perhaps that is one reason the Fed has been able to delay raising its target interest rate.

However, that is just one piece of data. The CPI less food and energy also gets reported. It was also up 0.2% in May. But over the last year, it is up 2.2%.

Energy is very volatile. All you have to do is look at a chart of oil prices over the last decade to see that.

It is correct to include energy prices when calculating the consumer price index, because consumers — especially American consumers — consume their share of energy.

The problem is that the volatility can distort the general trend with consumer prices. Since oil prices fell in 2015, it is still distorting the year-over-year CPI, making it seem lower than it really should be. This is why the CPI less food and energy is a useful statistic.

And then there is the median CPI as reported by the Cleveland Fed. This is my favorite statistic because it is using a median number (as opposed to an average). I like this number because it is stable. It does not move much.

In December 2015, the median CPI was 2.3% from the previous year. It moved to 2.4% in the first three months of 2016. For April and May of 2016, the median CPI was 2.5% year-over-year.

The median CPI does not jump all over the place like the regular CPI. For this reason, it can actually be more reliable in judging whether price inflation is trending up or down.

It’s Just a Government Statistic

There is no shortage of criticism out there for the CPI. There are many accusations that it is understated, manipulated, misleading, etc.

As a skeptic and critic of the government and central bank, I can completely sympathize. The CPI is a statistic that is compiled and delivered to us by the government via the Federal Reserve System.

There is also criticism of the index because of changes that are made, as well as hedonic adjustments. This means prices are often adjusted due to considerations in increasing quality and technological advances.

On the flip side, it would be impossible to maintain a consumer price index that never makes adjustments or calculation changes. We could still be including the prices of buggy whips and long-distance telephone calls.

In reality, it is impossible to get a perfect consumer price index. It is impossible to account for the varying quality and the satisfaction that it brings to people. In addition, we all value everything subjectively.

If the price of gasoline goes up by 20%, this may mean little to a retired guy who lives one mile from the grocery store and only leaves the house twice a week. Meanwhile, the guy who commutes 100 miles per day in his SUV is getting hammered.

The retired guy’s CPI has barely moved, unless the higher gas prices have impacted the price of other items that he consumes. The guy with the long commute has seen his personal CPI increase quite a bit.

Still, it is understandable why the Fed or any central bank would want to understate consumer price inflation. It means less blame on them, as well as more flexibility.

Originally, inflation was commonly defined as an increase in the money supply. One of the consequences of this was increasing prices. The government and bankers somehow managed to shift the definition of inflation to mean an increase in prices (the consequence of inflation).

If you have high inflation as defined by an increasing money supply, then you can only blame the central bank. But if you have high inflation as defined by increasing prices, then you can blame shortages, increasing economic activity, greedy businessmen, or whatever the excuse of the day is.

In other words, this change in definition deflects criticism from the Fed. If inflation were just an increase in the money supply, then there would be nobody else to blame.

2 Reasons to Pay Attention to the CPI

So why would I even be discussing the CPI with all of that said?

First, it is useful in looking at trends. As mentioned above, the median CPI has ticked up to 2.5% year-over-year. This is not earth shattering. It is nowhere near the double-digit inflation of the 1970s.

But it tells us that if consumer price inflation is going anywhere, it may be slightly trending upwards. This could quickly change with another month of data, but that is where we are now.

Second, and more importantly, the CPI is useful to us because the Fed members pay attention to it. If it matters to the Fed, then it should matter to us.

It’s not that I want the Fed to matter to us. But the Fed is the entity that has a monopoly over the money that we use. It can indirectly impact market interest rates, and it can directly change the money supply.

If the Fed thinks inflation is picking up, then maybe we will see rate hikes faster than what is now predicted. If the Fed is concentrating on the CPI number without looking at the median CPI, then maybe we won’t see any Fed rate hikes in 2016.

Your Personal CPI

When you look at a breakdown of the median CPI, there is a lot of volatility within this stable number. When you look at the one-month change on an annualized basis, processed fruits and vegetables went down 15.4% in May.

On the flip side, watches and jewelry went up 61.4%. The rent of primary residences went up 4.4%. Medical care services went up 6.2%.

Watches and jewelry don’t really mean anything to most of us because we can just simply choose not to buy them. We can’t say the same thing about food and rent. And while medical services are not always a necessity, they are for some people.

And that is where we get to the heart of the matter. It isn’t just a matter of whether the CPI is increasing or decreasing. It is a matter of what is happening to the consumer goods that we actually need.

According to the Federal Reserve Bank of Atlanta, wage growth has been mostly trending upwards since the end of 2009. The three-month moving average of median wage growth in May was 3.5%.

But when you talk to people on the street, you get a different picture. The average middle-class American family is struggling.

And I believe one of the major problems is that the costs for basic goods and services are going up faster than what is being indicated.

Sure, it is great that big-screen televisions are so cheap now. It is great that we can own iPads and smartphones. But meanwhile, it is a struggle to pay rent and the grocery bills each month. And the biggest killer of all has been health insurance, which is now one of the greatest expenses (sometimes the biggest) for the average American family. There are people paying more for health insurance than their mortgage.

So the Fed or Obama or anybody else can look at wage data and say things are looking up, but is this the reality of the situation?

We can continue to monitor the CPI figures so as to better guess what the Fed might do. If the Fed starts another round of QE based on an understated CPI, then that will be a signal to move into commodities, including possibly oil.

But the reported CPI is mostly relevant to your investments in the sense that it may impact the actions (or inaction) of the Fed. It doesn’t mean much to you on a day-to-day basis, especially since you have your own personal CPI that reflects your wants and needs.

If you feel that things are tighter than what the government is telling you, then you are not alone.

Until next time,

Geoffrey Pike for Wealth Daily