Here’s Exactly Why Fed’s Favorite Inflation Measure Is Creating Extreme Surprise Risk

One of my pet themes has been that the grossly understated official inflation measures will begin to catch up to reality, and when they do, look out. A couple weeks ago it was CPI, and last week it was the Fed’s favorite bogus inflation measure, the core PCE–the core Personal Consumption Expenditures Index.

Last week the BEA released the latest PCE numbers and, finally, they pointed to core personal consumption expenditures being above the Fed’s 2% target. Here’s how the BEA put it in the March 1 release:

The PCE price index increased 0.4 percent. Excluding food and energy, the PCE price index increased 0.3 percent.

If you annualize those numbers, which Wall Street and its media handmaidens love to do, the core PCE is 3.6%. Ooops, above target, finally! Here come the Fed’s interest rate increase ratifications (the Fed merely ratifies what has already happened in the market). But, on the other hand, the BEA also points out that year to year core PCE only rose 1.7%. The Fed must be really confused–which is de rigeur because the Fed never deals with reality in any case.

Oh, and by the way, “Real DPI decreased 0.2 percent in January and Real PCE decreased 0.3 percent.” That’s right. Real disposable income and real personal consumption expenditures were both negative! Given that the deflator used was almost certainly lower than actual inflation, the real declines are even worse than reported. Did you see that reported anywhere?

All of this nonsense misses the big picture. The Fed isn’t looking at inflation at all. It’s looking at a narrowly defined, and artificially suppressed measure of a tiny subset of the rise in the “general level of prices.” That’s what inflation actually is, according to the most widely recognized definition. As a result, the Fed has totally missed the fact that inflation has actually been raging out of control for years.

I’ll illustrate by comparing the core PCE with a couple of similar measures. These measures don’t pretend to measure “an increase in the general level of prices” either, but at least they are more reflective of the kind of inflation experienced by consumers as they go about their everyday lives, their actual “cost of living.” There’s no need for a long dissertation on these numbers. You can see for yourself below.

We think that David Stockman’s Flyover CPI comes the closest to how most American’s experience the actual cost of living. It includes a more accurate measure of housing inflation the FHFA monthly house price index and gives slightly higher weight to energy and medical costs. The core measures with which it is compared don’t include energy costs.

Sources: BLS, BEA

We used to call it the “cost of living” but that fell out of favor after the butchers at the BLS made steak into hamburger with hedonic adjustments, and removed home prices from the CPI in 1982.  So we’re pretending not to measure the “cost of living” as most Americans really experience it. We’re pretending to measure something else.

In reality what we’re measuring simply does not exist in the real world. That’s the Core PCE’s problem. No government index actually measures “inflation,” nor do they purport to. I challenge you to find the word in any BEA report of the PCE or any BLS report on the CPI. You won’t. Only the Fed officially pretends  that the core PCE measures inflation.

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures

Since the Fed says the PCE measures inflation, then “by God, Virginia, it must be true!”  At least, that’s how the 8-year olds in the economics religion and in the financial media see it.

I have personally never made it my business to find out exactly how the BEA suppresses PCE even more than it suppresses CPI. It would be a waste of time because both understate inflation generally. I just knew that PCE used different component weightings than CPI, and that this resulted in an even lower rate of increase in… whatever they purport to measure that the Fed pretends is inflation. We could readily see the suppressive effect in comparison of CPI and PCE. That was good enough for me.

But my curiosity got the better of me today. So I went Googling. And I found refreshingly honest, yet still mind boggling explanation from the Cleveland Fed. I’ve put key phrases in bold text.

The baskets aren’t the same, and it turns out that the biggest differences between the CPI and PCE arise from the differences in their baskets.

The first difference is sometimes called the weight effect. In calculating an index number, which is a sort of average, some prices get a heavier weight than others. People spend more on some items than others, so they are a larger part of the basket and thus get more weight in the index. For example, spending is affected more if the price of gasoline rises than if the price of limes goes up. The two indexes have different estimates of the appropriate basket. The CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling.

The BLS weights housing at 41% of core CPI. But actual housing prices are not included at all. Instead the BLS makes up a phony measure called Owners Equivalent Rent. It tends to run at less than half the rate of house price inflation. That goes a long way toward cutting headline CPI down to where they want it.

Another aspect of the baskets that leads to differences is referred to as coverage or scope. The CPI only covers out-of-pocket expenditures on goods and services purchased. It excludes other expenditures that are not paid for directly, for example, medical care paid for by employer-provided insurance, Medicare, and Medicaid. These are, however, included in the PCE.

So only more rapidly rising out of pocket medical costs are included in CPI, while artificial prices determined by dictat by Medicare, Medicaid and big insurers are not. But they are included in PCE.  Yeah, that’s the ticket.

Finally, the indexes differ in how they account for changes in the basket. This is referred to as the formula effect, because the indexes themselves are calculated using different formulae. The details can get quite complicated, but the gist of the matter is that the PCE tries to account for substitution between goods when one good gets more expensive. Thus, if the price of bread goes up, people buy less bread, and the PCE uses a new basket of goods that accounts for people buying less bread. The CPI uses the same basket as before (again, roughly; the details get complicated).

IF THE PRICE OF A COMPONENT RISES, WE LOWER ITS WEIGHT IN THE PCE? Is that what they’re saying? That’s just bullshit. I’m sorry, but I can’t say it any other way than that. It’s ridiculous, and it’s obviously a suppression tactic. If you purport to be measuring inflation then everything should be included and you shouldn’t be fiddling around with weights. Do we want to know how much “the general level of prices” is rising or not?

Of course, none of these measures even attempts to measure asset prices. So they don’t measure “the general level of prices.”

The practical issue now becomes how long will the immense lag and suppression built in to the Fed’s preferred measure continue to mislead the Fed, Wall Street, and the media into thinking inflation is low. These measures will never fully catch up with reality, but OER will hew toward actual house price increases over time. As that measure catches up, the narrow measure favored by the Fed will eventually move above the 2% target to an increasing degree. If the 0.3% monthly move is repeated a few more times, voila! We’re there.

Then the real panic will be on as the Fed attempts to tighten for real.

Follow Lee’s weekly market timing reports on gold, as well as mining stocks and ETFs, including trading recommendations, in the Wall Street Examiner Pro Trader Precious Metals Updates.

Follow Lee’s weekly market timing reports, including ETF trading recommendations, in the Wall Street Examiner Pro Trader Market Updates. Try the service risk free for 90 days.