RateWatch #425 Inflation or the Lack Thereof

September 18, 2004 by Dick Lepre

What's Happening

Consumer Sentiment (predisposition to spend) is at 95.8. This is below consensus and slightly below previous but is not at a level of concern. The bull market is solidifying. There are some
details that indicate that we will not see the wild move that we saw in the last bull market when yields were at 30 year lows. One of the factors that drove Treasury yields so low last time was "convexity buying" by holders of mortgage backed securities. Unless yields start to test the previous levels, we are unlikely to see this happen again and may have to settle for a more typical bull market. In any case, yields (and rates) will trend downward for the next 12-14 months.

On Thursday CPI came out at +0.1%. This was the headline economic story of the week. The first story in the on-line edition of The New York Times on Thursday was headlined "Consumer Prices Climb; Jobless Claims Up". While that statement is factual it hardly represents the core truth that inflation is contained. During the time that this story was on the NY Times site the yield on the 10-year Treasury fell to 4.07%. It fell because inflation was contained.  To be fair, on Friday a NYT reporter did an in-depth piece titled "Inflation in Check, Bond Prices Rise Briskly."

Lack of objectivity in choosing what goes on the front page and in annoying headlines such as mentioned above has diminished the status of the New York Times. For my taste, they can put whatever they want on the op-ed page but have an obligation to not bring their personal opinions and tastes onto the front page. 

In terms of reporting, the New York Times still, in my opinion, sets the standard for how newspaper reporting should be done.  Stories are put into context with comprehensive background material.

My personal view of newspapers is that the most important thing that they do is cover local news.
A good example is the Los Angeles Times which has large amounts of local coverage of a very large geographic region.

I remember when I was a kid growing up in New York City my dad would send me to buy the evening newspaper which got to the newsstand at (if I remember correctly) some time between 8 and 9 PM.  That was the news.  Now the news is delivered on the Internet and cable on CNN, Fox and MSNBC. CNN really started this trend.  Network news programs (Rather, Jennings, Brokaw) has lost something like 75% of their viewers since CNN started.

The net effect of all of this is good.  The truth is out there.  It just ain't in one place.

My apologies for digressing.  I wanted to talk about inflation.  The important point is that as
long as inflation is contained certain problems are minimized.  For example, the Federal budget
deficit.  If inflation is low (core is +1.7% year-over-year) and the yield on the 5-year Treasury
is 3.31% they the real cost of "paying later" is 1.61% which is small. As Greenspan pointed
out last week, budget deficits become problems when interest rates rise significantly and it
is contained inflation that best keeps rates low.

The Measures of Inflation

Inflation is well-contained. By "inflation" we are almost always talking about CPI. But, there are other measures of inflation. Some of these are more forward looking than the backward looking, "this is what happened last month" nature of CPI.

Consumer Price Index (CPI)

CPI is a measure of the average level of  prices of a fixed "market basket" of goods
and services purchased by consumers (food, clothing, utilities etc.). CPI is an indicator
of inflation on the retail level.

This is calculated every month by the Bureau of Labor Statistics and available online
at http://www.bls.gov/cpi/

The are 2 major CPI's:
CPI-U (U is for Urban) which represents about 80 percent of the total U.S. population. It is based on the expenditures reported by almost all urban residents, including professional employees, the self-employed, the poor, the unemployed, and retired persons as well as urban wage earners and clerical workers.

CPI-W is based on the expenditures of urban households that meet additional requirements:
More than one-half of the household's income must come from clerical or wage occupations
and at least one of the household's earners must have been employed for at least 37 weeks during the previous 12 months. CPI-W represents about 37% of the population.

It is the CPI-U which everyone (including me) calls "CPI".

CPI includes:
Food and beverages (cookies, cereals, cheese, coffee, chicken, beer and ale, restaurant meals)

Housing (residential rent, homeowners' costs, fuel oil, soaps and detergents)

Apparel and its upkeep (men's shirts, women's dresses, jewelry)

Transportation (airline fares, new and used cars, gasoline, car insurance)

Medical care (prescription drugs, eye care, physicians' services, hospital rooms)

Recreation (newspapers, toys, musical instruments, admissions);

Education and communication (tuition, postage, telephone services, computers);and

Other goods and services (haircuts, cosmetics, bank fees)

CPI is seasonally adjusted to cull apart the changes that are seasonal from the underlying
economic changes. Seasonal changes are fluctuations in prices that occur at the same time very year. They might be due to: automobile model changeovers, weather and holidays. For example, gasoline costs more in the summer, tomatoes cost more in the winter.

The unadjusted data is what people actually pay. The adjusted data is what is reported in the
media. CPI is a number that reflects prices with 1982-1984 averages as 100.0. The percentage
changes announced month-to-month are adjusted so as to be a percent of the value of the last
month's index.

CPI is based on a very large sample of goods in a very large sample of places. The one criticism that can be made is that it takes no account for what people actually buy. If, because of El Nino, tomatoes which cost $1.39 a pound in March now cost $4.59 a pound, people will diminish their purchases. Because of this, CPI is, in terms of what people actually buy, slightly overstated.


PPI is the Producer Price Index - this measures the average change over time in the selling prices
received by domestic producers of goods and services. PPI's measure price change from the
perspective of the seller. This varies from CPI this is a measure of price change from the buyer’s
perspective. Sellers' and buyers' prices may differ due to subsidies, taxes, and the dynamics
of distribution costs. They also are affected by the "depth" of competition of the marketplace.

Implicit Price Deflator

While CPI might be the "Dow" of Inflation it is, in essence, a measure of the price that people pay for things and services. The economy, however consists of a bit more than individuals.

A broad measure of economic activity is GDP (Gross Domestic Product). The GDP Implicit
Price Deflator or IPD is based on the Gross Domestic Product and therefore reflects price
changes in all goods and services transactions in the United States, including the consumer,
producer, investment, government and international sectors. The IPD for GDP takes into account
the price changes of the goods and services that actually happened. The IPD for the GDP is, thus, a more meaningful measure of inflation than either CPI or PPI.

IPD might, for example, be used to adjust the cost of a long term projects such as Civil Engineering projects. The EPA, for example, writes it into the bids for toxic cleanup
projects. If one wanted to compare the economic impact of natural disasters from different
periods, it would be appropriate to normalize the dollar losses at the time that the occurred
using IPDs rather than CPIs.


ECI is the Employment Cost Index. When we were hearing about a tight labor market this might be where inflation would first show. ECI is the cost of labor on a fixed basket of occupations. This eliminates the effect of the influence of employment shifts among occupations. While the average hourly earnings data would be affected by a shift in the occupational composition of the workforce and would appear as a wage gains, ECI would not be affected. Wages & salaries account for about 72% of the ECI. The rest is benefit costs.

Data is available from BLS at:


FIG is a product of Economic Cycle Research Institute, Inc. This is a construct that is forward looking. It is a way to predict future inflation. The previously discussed indices take note of inflation that has already occurred. ECRI has a WWW site at http://www.businesscycle.com

This site is a, sort of, Bible on inflation. FIG is reputed to be able to predict inflation up to a year ahead.

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