Global cc: On a Note About Inflation Confusions

By: Michael Ashton | Fri, May 2, 2014
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I haven't written in a couple of weeks - a combination of quiet markets, and a lack of intersection between stuff that's interesting to write about and my having time to write - but I thought I would "global cc" everyone on something I just wrote in a private email about some common misconceptions regarding the CPI:

A friend and longtime reader (name withheld) writes:

Mike,

I thought you might find these interesting....
davidstockmanscontracorner.com/memo-to-d...
davidstockmanscontracorner.com/inside-th...

My response is below:

Thanks. Unfortunately Stockman doesn't understand what he's talking about. He understands better than most, but then he starts saying how the BLS asks homeowners what their homes would rent for...which they do, but only to determine weights, every couple of years, not to determine OER. It says this very clear in a paper on the BLS website called "Treatment of Owner-Occupied Housing in the CPI:"

"To obtain the expenditure weights for the market basket...Homeowners are asked the often-cited question:

If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?

This is the only place where the answers to this question is used; in determining the share of the market basket. We do not use this question in measuring the change in the price of shelter services."

For that purpose - calculating inflation itself - a survey of actual rents is used. I can understand how the casual observer doesn't 'get' this, but there's no excuse for Stockman not to know, especially if he is railing about the CPI...he should take some time to understand its main piece.

In short, Stockman writes a good populist screed, but he avoids the main questions:

1. Is headline inflation a better predictor of future inflation than core inflation? Answer: No, even if we can now realize that the rise in energy prices was a permanent feature of the decade ended in 2010, it tells us exactly nothing about whether those are likely to persist. The Fed uses core CPI not because they don't think people use cars (whenever a columnist uses that silly argument, I know they're just writing to please a certain audience), but because core CPI is persistent statistically in a way that headline is not. In fact, some Fed statisticians prefer median, or trimmed-mean, neither of which proscribes any particular category. So whining about how the Fed doesn't include the particular brand of inflation that concerns you misunderstands how and why policymakers actually use measures of inflation in policymaking.

2. Suppose the CPI represents a miserable mis-estimation of actual inflation. Then, pray tell, why does a trillion-dollar market based on that index get priced as if it is accurate? In Argentina, where the inflation numbers are made up, the inflation-linked bonds trade very cheap because they will pay off in a number that is assumed to be too low. And the bond yields are too high by roughly the amount that inflation is assumed to be understated in the future. Markets are efficient, especially big markets. How did the Fed manage to convince at least $1T in private money to misprice the bond market?

3. If the CPI is so wrong, so manipulated, then why to measures of inflation that the government has nothing to do with, like the Billion Prices Project, come up with the same number?

It's nice that Stockman has a following. And he's gotten the following partly by ranting about a number people love to hate. That gets him read, but it doesn't make him right.

 


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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
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Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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