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Pro-forma Inflation Revisited

Pro-forma Inflation Revisited

With the release of February’s CPI, Wall Street once again rejoices under
the delusion that there is no inflation. For the month of February the CPI
rose by.5%. However, seasonally adjusted, it only rose by.3%, and excluding
food and energy, it rose by only.2% It is the.2% figure, the “core” CPI,
which Wall Street and the Fed are celebrating despite the fact that.2% was
twice what had been forecast. However, the actual, unadjusted CPI, which
is what consumers really paid, increased.5%, for an annualized inflation
of over 6%.

If we look at what actually happened to prices in February, as apposed to
what government reports pretend happened, we see the following price increases:
soybeans 13.2%, corn 7.75%, copper 19%, silver 7%, lumber 11.3%, crude oil
12%, unleaded gasoline 11%, heating oil 9.5%, and natural gas 8.5%. Those percentages
are not annualized, they are the actual percentage gains during the month of
February alone! All of these prices have increased significantly thus far in
March as well.

Perhaps the most bizarre of Wall Street’s CPI rituals is the routine
exclusion of food and energy prices from the CPI because these components are
considered volatile. However, over the past several years, all of the volatility
has been in one direction, up. Therefore excluding food and energy on that
basis makes no sense. It is similar to a CEO excluding regularly occurring
expenses when reporting earnings by labeling them as extraordinary. To me “core” CPI
is the Fed’s own version of pro-forma inflation!

The “core” CPI is actually of little value since about 40% of it
is comprised of rent (either actual or owner-equivalent). In the current low
interest rate environment, which has drawn in an ever-widening pool of home
buyers, rents are being artificially suppressed. What’s more, the proliferation
of adjustable rate mortgages and no down payment loans have temporally turned
many renters into buyers; fully one third of first-time homebuyers are putting
zero down! As a result, the national rental vacancy rate is at a 40 year high,
and rents are under pressure. Therefore, the Fed’s inflationary monetary policy
is paradoxically helping contain rent increases which represent 40% of the “core” CPI,
while causing housing prices themselves, which are not even included in the
CPI, to soar. The more inflation the Fed creates, the lower the “core” CPI.
How convenient.

As an example, if a tenant who rents a two-bedroom apartment for $900 per
month discovers he can purchase a two bedroom condo with a zero down one year
ARM for only $800 per month, his landlord is forced to either lower the rent
or lose the tenant. Under a normal interest rate and credit environment (which
requires down payments), the barriers to purchasing condos would be much higher,
giving landlords the flexibility to raise rents.

In fact, one of the main factors restraining increases in the CPI is the low
interest rate environment. Interest rates represent the cost of capital. Businesses
are able to pass on their lower cost of capital to consumers in the form of
lower prices. One of the reasons that the landlord in the above example is
able to reduce the rent is that his interest costs are lower. Most landlords
have mortgages, and are able to pass on their lower interest payments to their
tenants in the form of lower rents. So, for example, even as General Motors
faces higher steel costs, higher energy costs, higher workman’s comp. fees,
and higher health insurance premiums, its cost of capital it significantly
lower. Lower capital costs help offset higher raw material and labor costs,
restraining the over all increase in consumer prices. The same is true for
businesses in general, particularly those with significant amounts of debt
to service.

The irony of the situation is extraordinary. The Fed points to an absence
of inflation as indicated by a benign “core” CPI as justification
for its low interest rate policy. But it is that very low interest rate policy
that is temporarily suppressing the “core” CPI. The prices that
are increasing, such as commodities and housing, are either excluded from
the “core”
CPI or from the index entirely.

The problem for the Fed is that once general price increases become so powerful
that they overwhelm the restraining pressure currently being exerted by rents,
the Fed will be forced to raise interest rates. That will have the immediate
effect of driving up the cost of capital, and increasing the cost of buying
a home. This will provide landlords with the impetus and the ability to raise
rents. Since rents represent 40% of the “core” CPI, each time the Fed raises
interest rates to fight inflation, the “core” CPI will rises faster, necessitating
further rate increases. Thus, the virtuous cycle becomes a vicious one. Housing
prices, on the other hand, will be falling, but those price declines will
not offset rising rents, as housing prices are not part of the CPI. An economy
that lives by “core” CPI, will die by it, as well.

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