Everyone's talking about inflation and deflation these
days, including myself, and that's because it's important.
And in order to really have an informed view on it, I think
it's important to actually look at how
inflation is defined.
And right here, I actually took a screenshot from my
Bloomberg terminal, of the basket of goods that makes up
the Consumer Price Index.
The index that sets everything from the coupons on Treasury
inflation-protected securities-- this is the index
that dictates what Social Security payments are, how
fast they're going to grow.
I'm sure a bunch of union agreements and pension
agreements are dependant on the CPI.
So this is the underlying basket of goods that really
tells us what inflation is.
At a first level, it's just fun to look at, because you
can compare your own household to what the government thinks
is a typical household.
For example, the government says that the typical
household spends 15.7% of their disposable income on--
and that's essentially the income that you take home
after paying taxes-- that they spend
15.7% on food and beverages.
That seems reasonable.
What's even more interesting is that they break it down.
They get very granular.
They try to figure out how much do you spend on eggs, and
fish, and poultry, and bakery products.
And that's good because, let's say, everything else stays
constant, but the price of eggs goes through the roof
because the Atkins diet becomes popular again.
Then you can actually make an informed decision as to why
inflation is going up or whether inflation will go up
going forward.
So that's just interesting to look at.
If you look at the major categories.
They have food and beverages, housing-- And I'm going to
come back to housing because this is, in general, just a
very interesting area to focus on, because it makes such a
big portion of the CPI.
And it's been such a big portion of the economic
picture, especially the last 10 years.
And obviously, it's become a big problem, has become a big
factor, in terms of what's causing the financial
crisis right now.
But housing is about 43% of disposable income.
Apparel: 3%.
Transportation: 15%.
This includes things like new vehicles, 4%,
used cars and trucks.
And I think the way they calculate this is, they say,
what percentage of Americans are driving new vehicles
versus used vehicles?
And they put fuel in here.
A lot of people, when I have this inflation-deflation
argument, they make this argument that China and India
are going to continue growing.
And because of that, commodities like oil and fuel
will continue to increase.
Although people were making that argument more last
summer, but even now people are making that argument.
But in a developed country, you see that motor fuel, even
though it hits your pocketbook on the margin, it isn't that
big a part of your total expenditure.
Especially when you compare it to things like housing.
And if you keep going down, medical care: 6%.
And then recreation.
They break it down and you could look this up.
I think the Bureau Of Labor Statistics has this broken
down as well, although it was much easier to get it on the
Bloomberg terminal.
Education: on average, 3%.
Obviously, if you're sending your kids to college that's a
much higher number, but, on average, if you take the
average household.
And finally, other goods and services: tobacco,
et cetera, et cetera.
So that one is just interesting to look at.
So whenever you have a discussion on the things that
may or may not drive inflation, it's important to
weigh them by these weightings that the CPI gives them, to
figure out what the actual impact on how we measure
inflation really will be.
With that said, if you think about it, really the biggest
portion of this is the housing piece.
I think that's fair.
Housing is a large percentage of most people's disposable
income, especially in a Western society.
You can imagine, if you live in a Third World country, and
you're barely getting by, food might be a huge part of your
expenditure, maybe rivaling housing if you've just kind of
built a house someplace.
But in a developed society, housing is a huge
percentage of it.
And I want to focus on one thing, and a lot of people
have talked about this.
And actually Mish once again, from Global Economic Analysis,
he really encouraged me to highlight this.
So within housing, obviously some people
rent, some people buy.
And so they give a 6% weighting of the whole basket
to rent, and then they give a roughly 24%, 25% weighting to
something that they call, owners' equivalent of rent of
primary residence.
So this is essentially their attempt to measure how much it
costs to live for people who own houses.
What's interesting, and you probably have caught onto it,
is they use the words: owners' equivalent rent.
So what they do, and this is the current methodology, they
don't say, how much is your mortgage?
They don't say, how much does it cost you to buy the house
and amortize it over the reasonable life of the house?
They actually just say, how much would it cost to rent
that house?
And they've kept waffling back and forth between-- sometimes
they just look for equivalent houses, and they say, well,
how much would that cost to rent?
At one point they were actually surveying people and
they would ask them, how much would it cost
to rent your house?
Which is probably even a worse number.
But the bottom line is, they're not factoring in
actual mortgages.
And you can even see it on the weighting.
Right when I looked at these numbers, I was like, well,
roughly 66% of people own houses.
How come this number isn't 66% relative to
this number, right?
It's closer to 80%.
I was like, oh, I know that's fair because more people
actually live in homes.
You could say that 66% of overall households own, but,
in general, homes are bigger, there might be
more people in it.
So you could either think of it on a person basis or maybe
on a square footage basis.
It makes a little bit more sense to weight houses higher.
But what's interesting here, is that this number,
especially if you add these two, housing in general is
about 30% of disposable income.
And traditionally that was the rule that a bank would use to
decide whether you can afford a house.
It shouldn't be more than a third of your disposal income,
or at least a mortgage payment shouldn't
be more than a third.
We know, especially over this last real estate bubble,
that's become a much, much larger percentage of people's
actual disposal income.
So you wonder, why is this weighting only 30% of
disposable income?
Well, that's because they use owners' equivalent rent.
They didn't actually say what people's
mortgage payments are.
So even though mortgage payments might be going
through the roof, even though the price of a house might be
going through the roof, it does not get reflected in the
CPI number as of the early `80s.
This is straight from the Bureau Of
Labor Statistics website.
And they wrote-- and they're actually using doublespeak
here, I just copied and pasted it straight from their website
--"until the early 1980s, the CPI used what is called the
asset price method to measure the change in the cost of
owner-occupied housing."
That makes sense and I'm not sure whether they just looked
at how much houses cost this year relative to last year and
then they put that into the weighting or they determined
the weighting based on people's average mortgage.
But in general, that's a good way to measure it, right?
Either your mortgage payment, or how much houses cost. They
said, "the asset price method treats the purchase of an
asset, such as a house, as it does the purchase of any
consumer good." Fair enough.
"Because the asset price method can lead to
inappropriate results--" And this is the key line. "Because
the asset price method can lead to inappropriate results
for goods that are purchased largely for investment
reasons." I agree with that.
If something is purchased largely for investment
reasons, if I'm purchasing gold, maybe that shouldn't be
included in the CPI, because it's largely for investment
reasons or for stocks.
But then they use this kind of completely disjointed logic.
They say, you know, "because asset price method can lead to
inappropriate results for goods that are purchased
largely for investment reasons, the CPI implemented
the rental equivalence approach to measuring price
change for owner-occupied housing." To me,
that makes no sense.
Owner-occupied is not purchased
for investment reasons.
That's a fair enough argument if you're doing it for
rentals, or if you're doing it for vacation homes.
But for actual owner-occupied housing, this
sentence makes no sense.
Based on their own rationale, there's no reason to transfer
to this rental equivalent approach.
The whole reason why I'm going here is, because in the early
`80s, I think 1983-- they say it right here, in January,
1983-- because they switched over to this, this kind of
inflation that we've seen in the price of houses,
especially the real estate bubble we've seen the last 10
years, in no way got incorporated into the
inflation numbers.
So it essentially understated them.
You can see that here.
Well, two things: not only did it understate it, but it
probably understated the weighting itself.
And Mish, he's had a couple of posts about this.
You really should use something like the
Case-Shiller Index on this line right here, instead of
doing this for owners' equivalent.
But I'd argue one step further.
Not only should you use something like the
Case-Shiller Index, but to actually gauge this weighting,
you should actually survey people and say, what
percentage of your disposable income is dedicated to your
mortgage and other things related to owning a house?
And especially over the last seven years, I would guess,
and I'm almost sure about this, that it would be much
larger than 30% of your disposal income.
So not only was this number being understated, or the
growth in that number, because it didn't incorporate the
increase in housing prices, but this weighting itself was
understated.
And just to get a sense of how much, this is the
Case-Shiller Index.
And you could look up the Case-Shiller Index, but, in my
opinion, it's the best index for actual increases or
decreases in the price of homes.
You see from 2001 to 2006 roughly, houses were
increasing by 10% to 15% a year.
So if you use that instead of the rental equivalent, then
over the same timeframe-- I don't have a chart for rent,
but rent was not increasing at anywhere near this pace.
If anything, people were leaving apartments to buy
houses, so rent was actually staying pretty stable.
But 10% to 15%-- this is year over year growth, this is what
this chart is.
So 10% to 15%, if you weight that at 30% of the CPI basket,
then really the reported inflation number was being
understated by 3% to 5% a year.
And I'd argue that this weighting should have grown
over that time period because people were spending more and
more of their disposable income on
their mortgage payments.
So really it was probably understanding it by more.
Then this weighting should've been more like 40% and you
could have said you're understanding it by 4% to 6%.
And if you look here, this is the actual
reported CPI numbers.
What I'm saying is, over that timeframe, the real inflation
number should have been up here.
And then, now that we have actual deflation in home
prices, this is zero.
So now, the most recent Case-Shiller numbers say that
housing has depreciated by 20%.
We're essentially understating the deflation now.
So although right now the CPI has us at kind of the zero
mark, if you actually incorporated the real prices
of homes and you didn't use rents as a proxy for it, you
would actually get a much more negative number here.
And Mish actually did that on his blog.
And if you actually want to read his blog, which I highly
recommend, do a Google search for Mish, M-I-S-H.
And this is directly from his blog, so I have to give him
credit for that.
And what he did here is, he actually charted the actual
inflation numbers that were reported.
That's in blue.
And then on top of that, he put what he calls the
Case-Shiller CPI Index and that's in red.
And you see here, especially over the housing boom-- These
are the inflation numbers we got from the government.
They peaked out in the 4% or 5% range, which isn't low by
any stretch of the imagination, and that's
probably why the Feds started increasing interest rates
right around here, arguably at the worst possible time.
But if you look at the CS CPI, or the Case-Shiller CPI, you
could almost say that the real inflation actually peaked out
in the 8% range back here.
And you could argue that, if this was the actual number
that the Fed was using, it would have actually been a
much better policy tool, because they would have seen
the inflation pop up back here in January '03.
And they would have known that they were keeping their
monetary policy too loose back here and they could've avoided
this whipsawing that they did and in 2007 and 2008.
And I'd argue even further that even this number is
understanding the reality, because back here, as a
percentage of the actual CPI basket, he just took the CPI
numbers and replaced the year over year change essentially
into the same weighting as the current CPI numbers.
But if you actually weighted it based on the actual amount
of disposable income people were spending on their
mortgages, I would guess that it would have looked something
more like this.
And you would have seen actual inflation peak out here,
probably in the 10% or 11% range.
There's a lot of social commentary about this; why
they do it.
One argument is, that a lot of the government's or even
corporate liabilities are indexed to inflation.
You have an inflation index.
On the other hand, the sale of homes essentially transfers
wealth from one generation to another.
Especially when you have a huge increase in
the price of homes.
If they did this on purpose, and I'm guessing that they
did, it allows housing prices to increase dramatically.
And when housing prices increase dramatically, it
transfers wealth from the new buyer generation to the
retiree generation, so it helps subsidize the retirees.
And, at the same time, by taking it out of the actual
CPI index, it keeps the government's, and actually a
lot of other corporate, liabilities low.
Because now Social Security, it's
indexed to the CPI numbers.
So if the CPI numbers are not incorporating, are not raising
up here, you don't have to increase people's Social
Security payments.
And you kind of get to project this farce to people.
You say, oh, in inflation adjusted terms, you're doing
better than your parents' generation did.
Oh, but, by the way, you can afford 1/3 the house now.
And to some degree that's been propagated-- it's obviously
all falling apart now.
But the big takeaway from this, if I had to give you
just one, is that the CPI index is a
government created tool.
It's based on a survey and, not only has it not been the
same survey, but it's actively changed over the years.
And it's changed in ways that significantly impact the
actual numbers that are reported and, to some degree,
play into what I think the government
wants people to believe.
Anyway see you in the next video.