Fed’s Inflation Numbers Hard to Believe

The Fed’s line on inflation has been consistent – that we are not experiencing high inflation. Despite a Consumer Price Index that reveals inflation hovering at a 1% …

The Fed’s line on inflation has been consistent – that we are not experiencing high inflation. Despite a Consumer Price Index that reveals inflation hovering at a 1% annual rate, experts at MIT have developed an inflation index that takes other factors into account and are producing some interesting results. See the following article from The Street for more on this.

Inflation, as measured by the Consumer Price Index, is running at annual rate of 1.6% (including food and energy), and only 1.0% (excluding food and energy) over the past 12 months. Do you believe that? I mean, do you really believe that?

If you haven’t gotten in your car and paid for gas lately, dropped off the kids at school after paying their tuition, gone to the grocery store to buy some vegetables, visited your doctor to pay his bill, and renewed the pharmaceutical prescription that he ordered, perhaps you might believe in this low-inflation scenario.

But for those of us living in the here and now, how on earth can CPI be this low?

See, our government has every incentive to maintain a Goldilocks inflation level of "not too hot, and not too cold." If you want to know what that magical number is, the Federal Reserve recently hinted that a 1.6-2.0% annual inflation rate with anchored future inflationary expectations in that range would be ideal.

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Why such a low and stable number? Well, for one, various government expenditures such as paying Social Security benefits and interest expense on TIPS (Treasury Inflation Protected Securities) are CPI-based. And with today’s ballooning federal deficit, the government can’t afford significantly higher payment obligations.

Moreover, if the government allowed inflation figures to run too high, workers would demand wage increases while attempting to hoard items as a means to front-run future price increases, leading to an unstable economic environment whose outcome, unlike Goldilocks, would be anything but pretty. Think Egypt and rising food prices.

Enter the Internet, courtesy of two savvy MIT professors who likewise recognize the government’s incentive to give the public inflation statistics that may just miss the mark. The U.S. version of the MIT Inflation Index collects daily price fluctuations of roughly 550,000 items sold by over 50 online retailers. The MIT index aims to identify distortions to official data in various countries (such as Argentina), and to identify when businesses are able to pass-through their higher input (labor and materials) costs to consumers.

From its inception in March 2008 through the end of 2010, the U.S. version of the MIT index moved in relatively close alignment with the government’s inflation figures. Both indices showed a very low level of inflation throughout America. But guess what happened early this year that put a number of hedge funds into a tizzy?

You guessed it: From mid-January to mid-February, the U.S. version of the MIT index rose a sizzling 0.7%. Annualize that! What happened to our government’s annual inflation rate of 1.6%? And is this a statistic that merits getting in a number of hedge funds‘ crosshairs?

Well, it’s not such a straightforward proposition. Indeed, there are stark differences in the underlying composition of the MIT index versus the government’s inflation index as well as differences in the way in which each of these statistics are calculated. For one, the MIT index is tracking online shopping. Clearly, there are plenty of economic activities that fail to be transacted on the Internet. Secondly, the MIT index largely excludes services industries from its measure (which is where price weakness has been most visibly prevalent in our recent economic downturn and recovery).

So what’s the point? If these two measures are so markedly different, why bother with the comparison?

Here’s why. The MIT index "is not designed to forecast official inflation announcements, but to provide real-time information on major inflation trends." Real-time. Could it be that a couple of introspective MIT professors have figured out a quicker way to discern alarming real-time inflation trends than the Federal Reserve? Is this what my venture capitalist friends might call a "disruptive technology"? And does this index generate actionable information from which investors and hedge funds can act quickly and decisively to position themselves appropriately and make money (or at least to protect the real purchasing power of their assets)?

Funny you should ask. It turns out that the two MIT professors commented on their Web site on Feb. 16 that they have received a lot questions about this recent phenomenon and are being asked to answer the question: "Is it time to panic or not?" Their reply: Stay tuned. The jury is still in deliberation. Their index is but one way in which to measure price trends, and should be used as a complement to the macro models used by financial institutions. But they also gave this cautionary note: "This is ONE additional piece of information (a useful and relevant one)."

So a word to the wise from MIT: It might not hurt to start looking at non-CPI-related inflation hedges such as owning natural resource stocks, commodities and selected real estate. Even farmland ownership may be in order. And taking out a 30-year fixed-rate mortgage on your home to facilitate such purchases may be worth examining as well.
 
This article has been republished from The Street. You can also view this article at The Street, a site covering financial news, commentary, analysis, ratings, business and investment content.

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