In a year where inflation was supposedly no where to be found, in 2004 the Consumer Price Index rose by 3.3%, its largest gain since 2000. In fact, other then 2000 one has to go all the way back to 1991 to find a larger annual increase in the CPI. As alarming as these numbers are, the results would have been far worse if the deck had not been stacked.
As I have written repeatedly, today’s CPI is calculated quite differently than it was in 1991. In 1998 the Bureau of Labor Statistics began applying hedonic adjustments across a broad variety of goods, in effect discounting price increases for many categories of goods and services based on subjective evaluations of the changes in quality. In addition, the current housing bubble has had the paradoxical effect of artificially suppressing rents, which represent the largest component of the CPI (home prices have been excluded since 1983). Further, zero percent financing on new cars has temporally restrained used car prices, which are another large component of the CPI. Had the 2004 CPI not had the benefit of these three factors, and had been measured by the same yardstick used throughout most of the 70’s, 80’s and 90’s, who knows how much higher it would have been.
However, as short-term interest rates continue their ascent, rents and used car prices will therefore be able to rise more rapidly. Thus as the Fed raises rates, allegedly to restrain inflation, the process will have the paradoxical effect of increasing the CPI, particularly the so called “core???, with is so heavily weighted towards rents. More importantly, as producers, particularly those operating over seas, begin passing on higher production and transportation costs, as well as currency losses (which they have heretofore either absorbed or hedged), expect even larger consumer prices increases in 2005 and beyond.
Most importantly, considering how much more accommodative recent Fed policy has been, as compared to any previous period in history, future CPI gains are likely to be far greater, ironically making Wall Street’s claim that inflation in 2004 was tame, look accurate by comparison.