This Week: Andy asks, "Economists agree that the inflation rate is low but I feel like I have a lot less money. Why?"
Great question, Andy, I think a lot of people are wondering the same thing. Why are our inflation experts claiming that inflation is in check when food and gas prices are obviously soaring? Don't they pump their own gas, pay their own utility bills or do their own grocery shopping? The confusion is a result of what I call Governmath. Governmath is what you get when you combine government, economics and mathematics... confusion, chaos and a general state of stupid.
Should you care what the talking heads are saying and how they do their math? I think you should, and here’s why. The government uses the inflation index to determine how much they will budget to various programs, such as Social Security and Medicare. If the government underestimates the inflation rate, that means you will wind up receiving less social security income when you retire and there will be less help available from government programs like Medicare. Inflation can have a major impact on your future, so it's important that the government has an accurate way to measure it.
Headline Inflation Vs Core Inflation…
Please don't take what I'm about to tell you as a knock on the Fed, Andy, I actually think they do a pretty good job despite the government's general bumbling and interference. Managing our Monetary Policy is enormously complex and, the nature of their task requires that the Fed constantly make unpopular and contrarian decisions.
Today, the fed uses the Core Inflation rate to measure, track and forecast inflation. This measure excludes energy and food prices because the Fed believes that they are too volatile to be included. They’re afraid that including items that experience a lot of short-term volatility could exaggerate the rate and make inflation and inflation estimates unstable and inaccurate.
The biggest problem with the Fed’s core inflation calculation is that it is dated. They’ve been using the same methodology to exclude food since the 1950s and energy since the 1970s. The Fed is currently taking a lot of heat for this, most developed foreign countries have updated their calculations to include at least some food and energy items since they are having a major and sustained impact on the economy.
Unfortunately, Andy, you and I have to deal with the reality of inflation rather than the theory. The pain we are feeling at the pump and at the grocery store is a result of an increase in the Headline Inflation rate, which DOES include food and energy prices.
How different are Headline and Core Inflation? Through June 2008, the headline inflation is running at 4.2% while the core inflation is running at 2.3%. Last month, the reading for core came in at a modest 0.2% while the headline inflation rate was triple at 0.6%.
What’s the reality?
The reality is that, right now, we are underestimating the inflation rate, the Fed’s 50+ year old math is no longer a very accurate way to gauge inflation. Core Inflation removes volatile items like food and energy because the Fed wants to eliminate the “noise”. This means they believe that the recent swings in food and energy prices are only short-term and temporary fluctuations. For their math to work, prices have to return to their normal lower levels soon.
Sadly for us and for the Fed, that's not likely to happen. Why not? In the past, food and energy prices often experienced erratic short-term fluctuations (12 months or less) and then returned to normal levels, which made Core Inflation the more accurate measure. This time around, food and energy prices have been increasing rapidly for three straight years and there is no sign of relief in sight. We have experienced three years of strong price increases and they rapidly accelerated this past year as a result of a recession, a weakening dollar, and greater world demand. We will definitely get some relief eventually, and that will help, but not enough. We will never get back to the gas and food prices that we were paying three years ago.
The Core Inflation calculation is supposed to eliminate factors that can skew inflation by removing items that are prone to short-term fluctuation. However, food and energy have proven that they are not short-term, they have experienced three years of sharp and sustained increases. To me, this means that the Core calculation has eliminated the items that are driving inflation, not the items that are “noise”.
What’s the solution?
I sure wish there was a clear answer, Andy. If anyone had a magic wand that could fix the economy, I guarantee that they'd be waving it around like a maniac right now. There are some good signs, the Fed is starting to buy into the theory that headline inflation is the number to watch. Several prominent members of the Fed have recently spoken out about shifting attention TO the Headline Inflation Rate and AWAY from the Core Inflation Rate.
I’m not sure I buy into this approach though. While switching over to Headline Inflation is a quick fix that is certainly more accurate, we may only be replacing a bad calculation with a slightly less-bad calculation. Headline inflation includes everything, and while I think it’s better than the Core calculation, there are a lot of items lumped in that really ARE overly volatile and that SHOULD be excluded.
The most promising solution I’ve heard is a proposal made by Richard W. Fisher, CEO of the Federal Reserve Bank of Dallas. He proposes that we come up with a new calculation that is a hybrid of Core and Headline Inflation.
I won’t bore you with the math, I’ll just give you the high-level explanation. Economists would create an inflation gauge that is constantly updated to exclude the most volatile items in the measurement. This means that, each month, the items with the greatest price increases or decreases will be dropped from the calculation. This would allow us to reap the benefits of excluding erratic items (like the Core calculation) but benefit from including energy and food items such as restaurant meals, that have been very good historical inflation gauges.
This sounds reasonable to me. This approach would allow us to benefit from the strengths of both Core and Headline Inflation calculations and eliminate many of the weaknesses inherent in each at the same time. That’s the best solution I’ve seen, and I think it would provide a much more accurate measure of inflation than any of the calculations we’re using today.
Hope you found this answer useful, Andy.
Cheers,
Founder, Money-and-Investing.com
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