Robert Barone: Measuring inflation is inexact, biased process
I have written extensively about how “official” inflation is dramatically biased. I have often quoted figures published by economist John Williams (Shadowstats.com) that indicate how the CPI would be significantly higher if the 1980 computation methodology were used.
To further this argument, Ed Butowsky (Chapwood Investments, Dallas), has created an alternative Consumer Price Index (CPI). On a semiannual basis, for America’s 50 largest cities, the Chapwood Index measures the change in the prices of the 500 most frequently used and relevant items in a family’s budget. If you go to www.chapwoodindex.com, you can find a complete explanation of the Chapwood methodology.
The summary below shows, by year, both John Williams’ inflation estimates using the 1980 CPI methodology and a simple average of inflation from the Chapwood Index for the 50 largest U.S. cities (the Chapwood Index began in 2011).
• 2010 Williams: 8.9 percent
• 2011 Williams: 10.7 percent; Chapwood: 9.9 percent
• 2012 Williams: 9.7 percent; Chapwood: 10.7 percent
• 2013 Williams: 9.1 percent; Chapwood: 10.2 percent.
One thing is for sure: Real inflation is nowhere near the “official” 2 percent level. Given this data and the fact that corporate America gives pay raises based on the “official” CPI, it isn’t any wonder that America’s middle class is rapidly disappearing.
Yellen’s “noise” is getting louder as inflation grows
Fed Chair Yellen has said the recent upsurge in the inflation indicators is “noise.” The Fed has its own favorite measure of inflation — it is called the PCE Price Index (Personal Consumption Expenditure).
This has risen 1.8 percent in the past 12 months. But three months ago, the 12-month rise was 0.8 percent. This means that the annualized rate for the past three months is 4 percent. The volume of Yellen’s “noise” has surely been turned up!
A sea change in the monetary landscape
In Money Banking 101, students are taught about the magic money multiplier in the banking system; that given excess reserves created by the Fed, and a reserve requirement of 10 percent (which is today’s reserve requirement), banks could, in concert, increase the money supply tenfold.
Throughout the entire history of the Fed, until the financial crisis, excess reserves were de minimis.
For example, in August ’08, excess reserves were $1.9 billion (with a “b”). But because of experimental monetary policies (called quantitative easing (QE)) initiated by the Bernanke Fed and now practiced by all of the world’s major central banks, today, excess reserves just in the U.S. banking system are $2.6 trillion (with a “t”). You can see that, via the magic money multiplier, the banking system can increase the money supply by as much as $26trillion.
From the financial crisis to the end of 2013, because of Dodd-Frank, Basel III, and other regulatory and capital rules, banks elected not to significantly increase their lending to the private sector.
For example, capital rules require that a bank have “uncommitted capital” to make a loan to the private sector, but no capital is needed to buy U.S. Treasury securities.
Given 0 percent borrowing rates and 2 percent to 3 percent returns on Treasuries, some of the money flowed to the government to buy newly created government debt (and Congress and the administration were grateful), but most of it ($2.6 trillion) stayed idle at the Fed earning 0.25 percent interest.
As a result, the magic money multiplier did not occur. That all began to change in the first quarter of 2014 (despite the weather). In that quarter, new commercial and industrial loans in the nation’s banking system set a new record ($96.8 billion), the highest level by far in the 17-year history of the series.
If this pattern continues, it will signal a sea change in the monetary landscape as the money multiplier will quickly come back to life.
Fed painted into a corner by its outlook, policies
You can see that the Fed has really painted itself into a corner. What can they do if the money multiplier reappears? In reality, although they have tested some experimental tools (reverse repos), it all comes down to raising interest rates paid on those excess reserves to discourage bank lending. In the end, the rate paid by the Fed would have to compete with rates banks could charge the private sector.
You can see the inflationary implications — potentially up to $26 trillion of new money if the Fed did nothing — and the resulting inevitable rise in interest rates as they try to control that new money creation in the banking system.
Conclusions and investment implications derived
As discussed above, while “official” inflation is low, real inflation is high and is likely to ratchet up, given the labor market tightness I have discussed in previous columns, rising capacity utilization and, now, rising bank lending. Eventually, “official” inflation will rise with interest rates following in lock step.
For investors, the risk of holding longer duration fixed assets is just too great, given what must inevitably play out.
While high-yield assets have had a great run for several years, they now appear to be overpriced and particularly vulnerable to price depreciation should market expectations of inflation suddenly emerge.
Investors needing fixed-asset investments should move to TIPS (Treasury Inflation Protected Securities), which protect investors from price depreciation due to inflation’s influence on interest rates.
As inflation emerges, hard assets, like REITs, and energy producers and associated industries will benefit. And a growing economy, even at 3 percent, will be a great tail wind for those investments.
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and currently is a director for the AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the finance investment committee. Barone is available to discuss client investment needs. Call him at 775-284-7778.