Is Inflation Truly a Threat?
John Mauldin's Outside the Box

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Welcome to the inaugural edition of "Outside the Box." Each week, I read hundreds of articles, reports, books, newsletters, etc. Each week, I and my staff will bring you one essay which we think is worthy of your time. The only requirement is that the article should make us think, and perhaps challenge our assumptions. The subject matter will be quite varied and will come from many sources. There will be no requirement that I agree with the writer or the thinking, just that it offer thoughtful analysis which challenge our minds.

The first essay will come to us from my good friend, Gary Shilling, who has been enlightening me with his financial and economic commentary for many years. This letter will certainly be "Outside the Box" for many of you, as it will challenge some basic assumptions you have about the inflation/deflation debate.

Many readers of my weekly "Thoughts From the Frontline" write in to point out that they believe the Consumer Price Index (CPI) reported by the government understate the true inflation rate. Gary agrees that the CPI might not reflect the true inflation rate, but claims that the CPI is overstated rather than understated. The argument and data that follows might not change your views, but it will give you an alternate way to think about the CPI. And if Gary is right, that means long term rates may be coming down over time. It also has significant implications for Fed policy and our own investment portfolios.

So lets get ready to think "Outside the Box".

Is Inflation Truly A Threat?

A revival in inflation in the U.S. has been a major concern of investors. Until recently, the spotlight was on employment, but the recent pickup in payroll jobs, spotty as it may be, has convinced many that more stable job increases are ahead. So inflation worries have risen, along with the Consumer Price Index, in recent months. 

The Fed professes to not be overly concerned, despite the congenital fear of rising goods and services prices by central bankers around the globe. Chairman Alan Greenspan weighed in on the matter recently when he said the Fed's "general view is that inflationary pressures are not likely to be a serious concern in the period ahead." Of course, this statement may have been in response to future markets, which anticipate a rapid rise in the federal funds rate. Still, on Sept. 8, he went further and said, "despite the rise in oil prices through mid August, inflation, and inflation expectations, has eased in recent months."

Still, many Americans, including lots of investors, think inflation is on the rise, and that the Fed is behind the curve. In fact, many never believed that consumer inflation rates were running close to 1%, as reported recently, even after volatile food and energy components are removed (Chart 1). They also didn't believe that producer prices for finished goods were actually declining (Chart 2).

They also worry that the recent leap in commodity prices (Chart 3) will soon feed through to finished goods producer prices and then consumer prices. These worriers aren't aware that there is so much value added between raw materials and finished goods by labor, transportation, packaging, capital equipment, etc. that a 1% rise in raw materials prices only increases finished goods prices by 0.07% and less for consumer prices. A loaf of bread contains only a few pennies worth of wheat. And this effect is falling as goods contain less in materials and more in intellectual content. A century ago, steel was a major good; producing it takes lots of iron ore, coking coal and limestone. Today, semiconductor chips are important but require a little silicon and fine wire. The rest of their value is brain power. 

The widespread fears of inflation are understandable. As we've discussed many times in past reports, historically inflation is a wartime phenomenon when government spending is huge, while deflation reigns in peacetime. Still, the nation suffered a uniquely long 60 years of war, which started with rearmament in the late 1930s, was followed by World War II, which promptly gave way to the Cold War that was augmented by the War on Poverty. So, most Americans have never experienced anything but inflation, which they believe is the way God made the world. 

Furthermore, human nature puts more emphasis on rising prices that may strain household budgets than on falling costs. Maybe that's why we tend to think that whenever we pay lower prices, it's the result of our smart shopping and bargaining skills. Airline ticket costs are falling due to competition from discount airlines, but many people think they're responsible for their cheaper tickets as they visit airfare websites and pick the lowest fares (Chart 4). But higher prices are the work of greedy corporations and other unassailable forces, probably the devil himself. Who doesn't feel helpless, both physically and financially, in the face of rising medical costs (Chart 4)?

There's also a strong tendency to remember price changes on frequently purchased items, but can you recall what you paid for your last water heater? You only replace it when there's water on the floorand you hope that's at 20 year or longer intervals. And the rising prices of many frequently purchased items, even though they are small parts of household budgets, give many the impression that inflation is rampant.

This year, Middle East risks and other factors pushed up the price of crude oil to nearly $50 per barrel (Chart 5) and gasoline at the pump followed with a vengeance (Chart 6)leaping 40% from December 2003 to their late May peak of more than $2 per gallonin view of the lack of refining capacity in the U.S. The spike in this frequently purchased item convinces consumers that inflation is rampant even though gasoline only accounts for 2.7% of consumer outlays.

Milk accounts for even less, 0.2%, but the 10% plus jump in milk prices in the past year (Chart 6) conveys the same impression. And since gasoline and milk are necessities for most households, price hikes are especially worrying and convince many that inflation in general is spiraling upward even though these two items account for a very small portion of consumer outlays.

This concentration on small purchases neglects the big price declines in big ticket, infrequently purchased items that are often discretionary and can be postponed if price increases appear temporaryor delayed if further price drops are expected. New and used vehicles (Chart 7) are in this category; outlays for autos and parts account for 5.2% of consumer spending. Computers are another example and, adjusted for the rise in computing power, their cost to consumers has virtually collapsed in the last 25 years while they have become more and more important expenditures (Chart 8).

Consumers do tend to neglect this important aspect of price indicesthe adjustments for quality improvements of the various items. This is needed to account for the fact that today's laptop computer has more computing power than huge mainframe machines of 40 years ago. Even if a washing machine costs the same as a decade ago, the modern front-loading models are more convenient and use less energy and water. These quality enhancements are often forgotten even if people remember what they paid 10 years ago.

To be sure, the measurement of quality improvements are ultimately judgment .calls by the statisticians at the Bureau of Labor Statistics who compute the producer and consumer price indices. If additional computing power is needed just to run a computer's operating system, is it a quality improvement? Maybe not, but what if that system facilitates more complex computing tasks? 

Despite the widespread belief that inflation is much higher than reported, the evidence is that the Consumer Price Index is overstated. A congressional study found that the CPI was biased upward in several areas. First, since the index has fixed weights, it doesn't account for the tendency to buy more of what's cheap and less of what's expensive. When apple prices fall and orange prices rise, consumers buy more apples and fewer oranges. In contrast, the deflator for personal consumption in the GDP accounts is weighted by the volume of purchases in the quarter in question. This is an important reason why it records lower inflation than the CPI (Chart 9).

Second, the group of retail stores sampled monthly in the government survey of selling prices changes slowly over time. As a result, rapidly expanding discounters like Wal-Mart (Chart 10) are underreported while dying full-list price mom-and-pop outlets are over weighted. 

Also, quality improvements are understated, meaning that prices are recorded as higher than they would be with proper adjustment. Computers are one example, and Chart 11 shows the vast difference between business spending in nominal and real terms in the GDP accounts.
The difference reflects quality improvements, essentially more computer power per dollar spent.

Another upward bias in the CPI results from the fixed-weight base period, currently 1982-1984. DVD players, wireless phones and lots of other new tech items didn't exist 20 years ago, but now account for significant portions of consumer spending. And their prices have fallen dramatically, meaning that the CPI is overstated since it doesn't include them. Chart 8 shows this clearly in the case of computers.

This study estimated that the annual increase in the CPI was overstated by 1.1%. While some subsequent adjustments reduced the CPI by 0.2% per year, it still shows much more inflation than an unbiased measure would report. 

In fact, the U.S. government has begun issuing chain-weighted CPI figures along with the 1982-1984 official numbers. The chained indices correct for the substitution and new products problems and consistently show lower inflation rates, both for the total CPI (Chart 12) and the core index that excludes food and energy (Chart 13).

But inflationary fears are so deeply embedded in most Americans that even if they were able to set aside all of their convictions that inflation is being vastly underestimated, they would still believe that the Federal Reserve is oblivious to the threat and is even promoting it with rapid monetary expansion, especially since the beginning of this year. The inflation hawks also point to areas like housing. Until 1983, the owner-occupied housing cost component of the CPI was based on the change in the purchase prices of new and existing residences. This approach was boosting the CPI considerably because in the 1970s, house prices were leaping as Americans sought havens from soaring inflation (Chart 14). Also, it recorded more CPI inflation than the average family experienced by far. If, say, one in 20 bought a new or existing house in a given year, that family felt a big cost increase, but the CPI spread it over all 20. So a housing cost increase was implied for the other 19 families when, in fact, they had none. Finally, many were buying bigger, more expensive houses than they really needed to get aboard the inflation train. To them, a house was not just an abode, the cost of which the CPI aims to measure, but also an investment that it doesn't intend to include. 

In 1983, the Bureau of Labor Statistics shifted to the rental equivalence approach. The exact measurement technique has changed back and forth over the years, but basically estimates the housing costs of primary residences as the rent on a similar rental house or apartment. Interestingly, the deflator for the personal consumption component of GDP, which the Fed favors over the CPI, uses the same approach (Chart 9).

In recent years, Americans have been rushing into single-family houses in response to low mortgage rates and very liberal lending terms, and also due to the investment appeal of rapidly rising prices. And they have been leaving rental apartments and houses in the process, which has moderated the increases in rentals. So, rentals and the owner-occupied rental equivalent component of the CPI have both shown declining inflation rates.

The inflation hawks believe that this has artificially depressed the CPI. Fair enough, and this is a big component. Owners' equivalent rent of primary residence is 23.4% of the CPI, almost four times the weight of actual rentals, 6.2%. Still, their recommendation that the CPI should return to the house price approach could reintroduce the problems discussed earlier. Clearly, the rapid rise in house prices in recent years, which has far outstripped its normal relation to the
CPI (Chart 15), reflects the shift in investment speculation from stocks in the late 1990s to residential real estate, and has nothing to do with basic shelter.

In any event, inflationary fears are so deeply embedded in most Americans that even if they could set aside all their convictions that the price indices are vastly underestimating inflation, they would still believe that the Fed is oblivious to the inflation threat and, indeed, is promoting it with rapid monetary expansion. 

In particular, they note the rapid growth in the money supply since the beginning of this year. My problem with this, though, is that, besides the traditional monetary measures, there are numerous other measures of money, like credit cards, which many consumers use to buy everything from groceries to gasoline to clothing. In any event, the money supply in the past year has grown less than nominal GDP and has been far from inflationary.

Furthermore, global excess capacity should keep American business pricing power in check and this, in turn, will maintain steady pressure on labor costs. In addition, the Wal-Marts of the world are another important factor in keeping inflation low as cost-cutting and lower prices are made possible by productivity enhancement.

In addition, consumer spending will moderate considerably, especially since the after tax income leaps due to tax cuts are history, the big bulges in defense and homeland security spending are probably over, and rising .interest rates will depress housing and virtually eliminate cash out refinancing. Also, high energy costs are, in effect, a tax on consumer incomes. In this environment, business spending on capital equipment, structures and inventories is unlikely to be strong enough to sustain rapid growth.

Some major financial institutions that borrowed cheap short term money to speculate in investment grade bonds, junk bonds, commodities, currencies and emerging market stocks and bonds may suffer severe difficulties as interest rates rise. Also, the housing bubble may collapse with widespread price declines that will have dire consequences for the 69% of American households that own their abodes. But even without these financial crises, the U.S. economy may well enter a recession in 2005. And, the downturn could be global if, as I expect, China suffers a hard landing in her current attempt to cool her white hot economy.

Indeed, the deflationary forces that I've been addressing since 1998 and 1999 are still hard at work. Besides global excess capacity and the increasing importance of mass retailers like Wal-Mart, robust productivity growth will be promoted by the ongoing burst of semiconductors, computers, telecommunications, the Internet, biotech and other new tech. These and other factors will, I believe, lead to an era of mild, 1% to 2% annual deflation ratesthe good deflation of new tech driven productivity increases and excess supply, as was seen in the U.S. in the late 1800s and 1920s, and not the bad deflation of deficient demand experienced during the Great Depression and, more recently, in Japan.

So I see the current rise in inflation as being one more brief up tick within the disinflationary trend of the past 23 years. And, so far, the Federal Reserve apparently agrees. The central bank will probably continue to raise its federal funds target rate at a moderate pace, perhaps by one-quarter of a point every six weeks at its policy meetings, through the end of the year.

And then, as concerns about inflation turn to renewed worries about deflation, the Federal Reserve will switch from raising to cutting interest rates.


This letter may not change your views on the CPI and inflation, but I hope it has helped you think about the subject from an alternative perspective.

One thing I have often pointed out to readers that contact me is that their perception of inflation hinges very much on the basket of goods they buy. Yes there are some goods that everyone must buy, like gas and food, but an older couple will probably spend much more on healthcare and a young couple will probably spend much more on cell phones, computers and furniture imported from china. So one group feels inflation is running at 10-15% annually while the other watches the price of their basket fall.

I would like to thank Gary for allowing me to use his thoughts on the CPI as the inaugural edition of the new letter. If you found Gary's perspectives interesting, he offers an even more in depth look at the current market trends and how they affect the investment world in a monthly 20-40 page newsletter called INSIGHT. To find out more about the letter and how to subscribe simply go to

Your thinking "Outside The Box" analyst,

John F. Mauldin
[email protected]


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 09-13-2004 4:10 AM by John Mauldin