Inflation: Pass It Through

The Federal Reserve has maintained a laissez-faire approach towards inflation, using the lack of “pass through” evidence as the basis in defending their position. After raising prices 20% last month, Dow Chemical (DOW) announced this morning it is increasing prices another 25% next month, and is instituting freight surcharges beginning in August. A survey of Chief Financial Officers released by Duke University last week* showed that nearly half of the CFOs surveyed intend to pass through higher commodity and energy costs their companies incur onto consumers. The CFOs expect prices for their products to rise by 4.1% over the next 12 months.

The Fed and their partners in the art of illusion over at the Bureau of Labor Statistics (BLS), have come up with some pretty creative ways over the years to mask the true rate of U.S. inflation. For readers interested in understanding more about what those methods are, I highly recommend Bill Gross’ June Investment Outlook.** Gross correctly asserts that if it wasn’t for statistical manipulation, the U.S. headline inflation rate would be inline with the global inflation rate which is currently 7%. The Fed and the government tries to brainwash us that we’re just so much more productive than other nations when the reality is that other countries take a straightforward approach in calculating inflation.

“Improving” inflation statistics has its roots in the Nixon administration with the debut of “core” inflation in the Consumer Price Index (CPI). Core inflation removes “volatile” food and energy costs – the things we must consume on a regular basis. The problem is that just like one Saturn cycle ago, there’s nothing “volatile” about food and energy costs that only go up. Of course the 1970s is the era that Bernanke does not recall, preferring like Don Quixote to focus his quest on things not applicable to today’s circumstances. As if core inflation was not ridiculous enough, the Fed has a “preferred” gauge of inflation, Core PCE (Personal Consumption Expenditures).

Core-ing out inflation wasn’t cutting enough of it, so in January 1983 the BLS began Owner’s Equivalent Rent (OER). OER comprises about 33% of the CPI. To quote the BLS: “It is Rental equivalence measures the change in the implicit rent, which is the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market.” OER is as real world ridiculous as core inflation. If you rent out your home, where do you live? Besides, a property has more value to an owner, both emotionally and economically, than it would be to a renter. This further makes the statistic ridiculous. Bill Gross describes OER as “a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of OER.”

The 1990s brought three more manipulations – product substitution, geometric weighting, and hedonic quality adjustments. With product substitution and geometric weighting, the BLS automatically assumes that if one item increases in price, consumers will substitute a lower cost alternative (or at least use less of the original product). That means I make a recipe using half an egg and can somehow safely store the other half for future use. If I regularly eat apples, I’ll substitute cheaper oranges. Geometric weighting does not factor items that cost the same but weigh less because the manufacturer has decreased the product amount. It’s not “environmentally friendly packaging” that has suddenly shrunk that cereal box and laundry detergent!

Hedonic quality adjustments is a fancy term to trick consumers into thinking they’re getting more for less. The government will tell you that the price increase of a computer, TV, or car is not really a price increase because you’re getting improved and/or more features for that item. Again, the government is making the assumption that you want these extras/improvements. When manufacturers debut new models, the former more basic models are discontinued. The government likes to tout electronics as a deflationary indicator which helps control inflation, yet how many times per month do people buy a new computer, camera, TV, etc. versus gas and groceries?

Other conveniently overlooked aspects of the CPI are all the forms of taxes that consumers pay, insurance costs, home maintenance costs and association fees.

The CPI peaked at 13.7% in March 1980. If the Federal Reserve wishes to avoid a repeat performance, they will back up their recent speeches with monetary policy that makes it clear inflation is unacceptable. Otherwise, by May 2009 the US could break its previously held record.

* The survey is part of a print edition article (“CEOs Predict Tough Times For Economy” by Kelly Evans) in the June 19, 2008 Wall Street Journal.

**Bill Gross is the founder of PIMCO, one of the largest specialty fixed income managers in the world. Former Fed Chairman Greenspan is a consultant to PIMCO. Gross frequently appears on CNBC and in the past has been a staunch advocate of a low Fed Funds rate. This is why his article was so surprising to me.

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