For the last few years the average American has bemoaned the fact that the Fed just doesn’t “get it” when it comes to understanding the real issues they are dealing with. In particular the outcry has focused on the fact that stripping out food and energy from the Consumer Price Index, and focusing on the core rate, misses what the average citizen has to deal with every day. We wrote in our post “Oil Price Spikes Feel Worse” about this disconnect between the governmental calculations of inflation and the inflation that consumers feel:
“Back in March 2011, on a Fed Reserve campaign to sell its monetary policy to ‘average Americans’; Fed Governor Bill Dudley tried to explain that while commodity prices are rising other prices are falling. ‘Today you can buy an iPad2 that costs the same as an iPad 1 that is twice as powerful, you have to look at the prices of all things.”
What he is addressing is called “hedonics”. Antony P. Mueller wrote a great piece on the “Illusions Of Hedonics” stating that ‘The Bureau of Labor Statistics (BLS) applies ‘hedonics’ when calculating the price indices and for the computation of the real gross domestic product and of productivity. The idea behind hedonics is to incorporate quality changes into prices. This way, a product may be on the market at a higher price, but when the product qualities have augmented more than the price in the eyes of the BLS, it will calculate that the price of this product has actually fallen.
Applying the hedonic technique to a host of goods and services means that even when prices were generally rising, but product improvement are deemed to be larger than the price increases, the calculated inflation rate will fall. With a lower inflation rate, the transformation of nominal gross domestic product (GDP) into real GDP will render a higher result. Likewise, given a constant labor input, productivity will increase. Hedonics opens the door to producing magical results: a lower inflation rate with generally rising prices, a higher growth rate although the economy may be weaker, and a higher productivity number, although productivity would have been declining without the hedonic imputations.’
It is important to understand this concept because this is why Bill Dudley was immediately lambasted by the reporters in the audience following his iPad statement with; ‘I can’t eat an iPad’ and ‘When was the last time YOU went to a grocery store?’“
The reason that this is particularly important to bring up today is that there is a very interesting shift occurring within CPI which is the primary reason why the Federal Reserve has made no mention of further Quantitative Easing. Core inflation is rising and is now outside the Fed’s targeted inflation zone of 1-2%. Past injections of stimulus have led to sharp rises in commodity prices and inflationary pressures. Previously the Fed was able to get away with it because core inflation was at very low levels. That is no longer the case today.
The media’s first glance at CPI had them spewing statements regarding the Fed getting its wish for easing inflation as lower energy costs suppressed the headline inflation number which was unchanged for November. However, the all-important core rate of inflation advanced a very strong 0.2% which was double expectations. More importantly, the core rate of inflation has surged from its 2010 lows to 2.2% currently.
Within the core, the indexes for shelter, medical care, apparel, and personal care all rose. As we have stated previously consumers are already seeing stagnating wages, declining real incomes and falling home prices. Now, not only are they already battling higher food and energy costs, which eased slightly in the recent report, but now upward pressure on other major components of consumption is coming at a very bad time.
Today’s release of the Consumer Price Index allows us to also update our composite inflation gauge remains at levels that have been consistent with slower economic growth and recessions. Now with the core rate also rising this further increases concerns as to the sustainability of not only consumer spending in the coming months ahead but also corporate profitability and sustainability of job growth.
Normally, when this gauge peaks at these levels and turns down the economy is either in, or soon will be in, a recession. Time will tell but the only time this did not occur was during the economic growth spurt that was driven by the massive credit induced/mortgage equity withdrawal boom during 2006-07. Unfortunately, the pain was only delayed a while before it set in with a vengeance in 2008. Could this time be different? Maybe, but I doubt it.