Live by the "core," die by the "core"

This week Wall Street finally began to acknowledge the possibility that all is not necessarily sanguine on the inflation front after all. This rather reluctant and long over do admission of the obvious came as a result of a .3% increase in April's core CPI, .1% greater than what had been expected. Though traders routinely ignore far more significant negative surprises with respect to headline inflation numbers, they are not as forgiving when it comes to the sacrosanct "core."

The interesting aspect of April's .3% rise in core CPI was that it was in large part the result rents, which are finally rising now that housing prices, which are excluded from the CPI entirely, are beginning to fall. Though this apparent irony may come as a surprise to Wall Street, it is precisely what I predicted would happen. Though I have written repeatedly on the folly of Wall Street's cult like fixation on "core" numbers, my March 2004 commentary reproduced below hits this week's nail right on its head. It was so dead on accurate in its forecast that I have little else to write on the subject other than "I told you so!"

Wednesday, March 17, 2004

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 rate 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.

Don't wait for the signs to appear. Protect your wealth and preserve you purchasing power before it's too late. Download my free research report on the powerful case for investing in foreign equities available atwww.researchreportone.com .