Bill Gross warns about underestimated inflation
The Economy May 26th, 2008
In his June 2008 Investment Outlook, Bill Gross tries to explain why the government is (intentionally or not) fooling us into believing that inflation is lower than it actually is.
I’ll tell you another area where we’ve been foolin’ ourselves and that’s the belief that inflation is under control. I laid out the case three years ago in an Investment Outlook titled, “Haute Con Job.” I wasn’t an inflationary Paul Revere or anything, but I joined others in arguing that our CPI numbers were not reflecting reality at the checkout counter. In the ensuing four years, the debate has been joined by the press and astute authors such as Kevin Phillips whose recent Bad Money is as good a summer read detailing the state of the economy and how we got here as an “informed” American could make.
The U.S. seems to differ from the rest of the world in how it computes its inflation rate in three primary ways: 1) hedonic quality adjustments, 2) calculations of housing costs via owners’ equivalent rent, and 3) geometric weighting/product substitution. The changes in all three areas have favored lower U.S. inflation and have taken place over the past 25 years, the first occurring in 1983 with the BLS decision to modify the cost of housing. It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – 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 the substituted owners’ equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.
In the 1990s the U.S. CPI was subjected to three additional changes that have not been adopted to the same degree (or at all) by other countries, each of which resulted in downward adjustments to our annual inflation rate. Product substitution and geometric weighting both presumed that more expensive goods and services would be used less and substituted with their less costly alternatives: more hamburger/less filet mignon when beef prices were rising, for example. In turn, hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durables. As your new model MAC or PC was going up in price by a hundred bucks or so, it was actually going down according to CPI calculations because it was twice as powerful. Hmmmmm? Bet your wallet didn’t really feel as good as the BLS did.
May 27th, 2008 at 10:45 am
It’s odd to turn to a blog on the housing price bubble and find an article on inflation that espouses using house prices to measure the cost of shelter. The primary reason that the CPI tracks rents is to avoid following the asset-value part of house prices, which you note here has been in a bubble.
If the CPI tracked house prices, you’d see tremendous inflation during the early 2000’s during the bubble, and if the bubble bursts, you’d see a large deflation. But if this is due to speculation in the housing market, it doesn’t really represent a true inflation and the CPI is better off using rent as a measure of housing costs.
Imagine the scenario if the BLS _did_ use house prices as a measure of inflation: the real-estate bubble bursts just as the baby-boomers are trying to sell their homes and retire, while our measure of inflation (and their social security payment) drops suddenly!
Using rent as a measure of the cost of owning a home isn’t perfect, but rents aren’t subject to the speculative swings that home prices are, and that’s a good thing.