Smoothing Out Inflation
October 17th, 2005
By John Mauldin

A Critical Juncture
What Will the Fed Do in 10 Days?
A Four-Pronged Attack Upon the US Economy
A Response From a General in the National Guard
Palo Alto, San Diego, Toronto and Houston

But first, I am compelled to make a comment on the Refco situation. Dennis Gartman has what he calls the cockroach theory. There is never one cockroach. If you see one, there are a lot of them in the walls. Observers have been seeing cockroaches at Refco for a long time. When the whole story comes out, it is not going to look good. How you can hide almost a half a billion in losses when going through a public offering is mind-boggling. Refco has had a long history of problems. Most never make the light of day, but there is one that you might recall.

This is the same firm that hid the transfer of $100,000 to the account of the wife of an obscure governor in Arkansas under the guise of trading cattle futures from information in the Wall Street Journal. The fact that Robert "Red" Bone was the broker for the general counsel of Tyson Foods was just a coincidence, I am sure. Hillary Rodham Clinton was allowed to order 10 cattle futures contracts, normally a $12,000 investment, in her first commodity trade in 1978 although she had only $1,000 in her account at the time. (Someone put cash in the account. Go figure.) And it gets murkier. Bottom line Refco was fined $250,000 for trading practices in cattle futures during that period, then the largest fine ever by the Chicago Mercantile Exchange.

As an aside, Senator Clinton is the only human being in the history of the trading world who could successfully turn $1,000 into $100,000 in a few months and then walk away and never execute another trade. I guess it was just too easy for her and she needed bigger challenges. But we were supposed to be talking about inflation.

Inflating the Numbers

A 12% jump in energy prices in September caused the CPI to rise by 1.2 % last month, the largest monthly increase since a 1.4% rise in March of 1980. The sharp rise in September followed increases of 0.5% in each of the prior two months, bringing the annual inflation rate for the quarter to 9.4%. (Dean Baker at CEPR)

However, if you look at the core inflation, without food or energy, it was just 0.1%, which is the same as it has been for the last five months. That means that the annual rate in the core inflation rate for the last quarter has been just 1.4%. But as we will show in a few paragraphs, that number doesn't tell the whole story. If you take out the housing component of the core index, you find that inflation has been rising 2.2% over the last quarter.

But the government changed the way it calculates the housing portion of the CPI back in 1982. If you use the old method, you would find that inflation is 5.3% today and even core inflation is 4.3%. This is a far cry from 2.2%. Can you imagine the 10 year bond prices if inflation was thought to be 5.6%? Somewhere north of 7%, I would think, and certainly high enough to put more than a crimp in housing prices.

If all of this sounds a bit confusing, that is because it is. Let's see if we can shed some light on the process.

The government currently assumes that housing costs are 23.158% of the Consumer Price Index. Prior to 1982, the housing cost numbers were based upon what you actually spent for the house and the related mortgage. After 1982, the Bureau of Labor Statistics (BLS) began to use an imputed number. They now use what is known as "owners' equivalent rent of primary residence" for the housing portion of the CPI. This is based on an economic theory that says that homeowners are essentially leasing the houses from themselves and paying implied rent for that service.

In theory, they are trying to figure out what it would cost you to rent your home. There's actually a rational reason for doing this and we will talk about that in a minute, but first let's look at the numbers.

Why are these imputed rents so low? Dean Baker tells us, "The main factor holding down shelter costs is the overbuilding associated with the housing bubble. This has led to record nationwide rental vacancy rates, which is putting downward pressure on rental prices in many of the areas with the biggest bubbles in housing prices. For example, rents in the New York City area rose by just 1.9 percent over the last year. They rose by 1.8 percent in Tampa, Florida and by just 0.3 percent in both Boston and San Francisco. (This is the inflation rate for the owners' equivalent rent index, which strips out utility prices.)"

How much does using imputed rent affect the CPI? Bill King wrote a few months ago, "In the Q1 GDP data, the US government has housing prices up only 1.1%, yet industry data shows double digit gains. And this week the June existing home sales data shows a 14.7% increase in the median house price. The BLS has 'owners' equivalent rent of primary residence' up only 2.2%.

"A couple of months ago, we delved into the BLS web site and discovered that "owners' equivalent rent of primary residence" is also suppose to account for real estate tax hikes. The Rockefeller Institute has the average US real estate tax bill +6% y/y. Of course it's double digits in most urban areas.

"Here's the math: 14.7% + 6% = 20.7%. But the BLS calculates this at 2.2%. 20.7% minus 2.2% = 18.5%. Now multiple by 23.158% and you get 4.28%. So by this metric, CPI is understated and thus GDP overstated, by 4.28%."

Remember that real GDP is calculated after inflation. You subtract the inflation rate from nominal GDP to get real GDP, which is the number everyone focuses on. So if inflation is higher than the BLS statistics show, which means GDP is not as high. The numbers have not changed all that much since the first quarter, so that would mean that GDP growth is almost non-existent if we used the old method of figuring housing costs.

If the CPI were 5.3%, we would be in a serious recession. But it doesn't feel like a recession. Profits are rising, unemployment is falling and things seem to be moving along just fine, thank you. So what gives? Is there some government conspiracy to understate inflation, so that they don't have to pay large increases in Social Security and other inflation indexed payments? The answer is not really.

If you look at a graph of home ownership cost you find that the numbers are actually very volatile. And I mean very volatile. In 1985, prices were rising at 6%, and just two years later prices were falling by 6%, but one year later 1988 prices are rising over 8%. Dramatic swings of 4-5% over a period of a year are quite common.

If you look at a graph of owners' equivalent rent you find that the volatility is much less and the moves take a longer time. Instead of 14 percentage points swings in just one year, you get 1-2%.

If you put these charts together, it almost looks like the imputed rent is an average mean of the actual costs. By that I mean that the actual costs swing both higher and lower, constantly reverting to the mean or long term average. Now that is not what it actually does from a calculation standpoint, but the chart sure looks that way.

In an odd sort of way, the imputed price seems to work rather well in smoothing the volatility. Otherwise we would have times when GDP said "recession" while the economy was growing and vice-versa. And this makes a certain sense.

Economists often claim that the CPI overstates inflation. And the housing component did do just that in the periods around 1987 (by 10% at one point!), from 1989 through 1994, briefly in 1996 and from 2001 through 2003.

But now, we are getting a rather large difference of almost 8% between actual costs and imputed rents! Looking back since 1982, this is the largest such difference of any one period.

What does that tell us? If this is indeed a mean reversion effect, as the chart makes it look to be, then we would expect either rents to rise or housing prices to become stable or fall, and not too far into the near future.

But as noted above, we now have record nationwide rental vacancy rates. Such does not portend for a rise in rents, so we are left with the thought that housing prices must at least stop growing, if not fall somewhat. And we read in paper after paper that they seem to be doing just that.

Could it be that the Fed rate increases are having an effect? Today, if you decided to buy a home and planned to pay it off in a few years, you find that a 15 year loan is cheaper than a one year arm. In fact, you would pay 5.625% a year with perfect credit! That is a far cry from the lower than 2% ARM rates of just a few years ago. (I know, Bloomberg says rates are lower than that, but try and get one!)

Gone are the days of the cheap mortgage. In the United States, refinancing a home last year brought in an astonishing $600 billion - or about 5% of GDP. That is, people "made" more money from refinancing their houses than they gained from salary increases, investment returns or any other source. (Daily Reckoning)

As housing price gains slow and then maybe stop, as interest rates continue to rise, that "cheap" money from borrowing against your home is going the way of the dodo, at least for awhile.

So, which is it? Is inflation running at a 9.4% clip, a 5.6% rate of just over 2%? The correct answer is all three. It just depends upon how you want to calculate the numbers and over what time period you want to calculate them.

But the various Fed governors seem to be calculating them using numbers which suggest inflation. Bert Dohmen brought this quote from Fed Governor Richard Fisher of Dallas to my attention, "We cannot let the equivalent of sclerosis block the arteries and disrupt the workings" of the economy, Fisher said. "Nor can we let the inflation virus infect the blood supply and poison the system."

As a little side note, using BLS statistics, health care costs are about 17.5% of consumption, but it is weighted much less in the CPI calculation. Healthcare is 4.649% of CPI; healthcare commodities are 1.484% of CPI. Healthcare is reportedly 15 to 17% of GDP. This presents a huge discrepancy in CPI weighting. If CPI healthcare costs were in tune with reality AND they had an accurate weighting, CPI would be substantially greater. (Bill King)

BLS assumes health care costs have risen about 4% a year for the last ten years. Anyone who is paying health insurance knows this is not the case.

Greenspan: Onward and Upward

Wayne Angell is a former Fed vice-chairman and Greenspan confidant. I have had the pleasure of meeting with him upon several occasions. He recently did an interview talking about Greenspan. Dennis Gartman gave me a synopsis.

Basically, Angell says ignore the Fed governors. This is still Alan Greenspan's Fed. He said that he expects Mr. Greenspan to leave office having completed his job of removing the monetary stimulation that has been in effect for the past several years, and that job shall not be done until the overnight Fed funds rate is at or just above the "equilibrium" level. He thinks that Greenspan will raise rates probably two more times and then vote to stop raising them at the last meeting he presides over, leaving the Fed rate at 4.25%.

(Note: Greenspan technically leaves January 31, 2006. The last Fed meeting he will preside at is that same day. That gives him three meetings left.)

This is a rather remarkable observation. It begs the question, "After Greenspan, who will lead the Fed?" Will one man be able to assert his authority as Greenspan has done, or will the board decide to show some independence? Will a new chairman echo the sentiments of Greenspan or those of the inflation hawks sitting on the board? Or will Greenspan's shadow so dominate the room that the last action he takes, stopping the rate increases, sets policy for the immediate future?

Over the past few years, the Fed has been in the process of becoming more transparent. But because there will be a new man in "charge," it is not altogether clear (pardon the pun) on how transparent things will be for at least a few meetings. The markets do not like confusion. As an aside, I would expect that period to be particularly prone to volatility and rumors. It could be a difficult trading period.

With increased energy costs percolating through the economy, with a potentially softer housing market, with rising interest rate costs and a reduced ability to borrow, I think we will see consumer spending start to slow in the first quarter of next year. It will be time to stop the rate increases by January. It might even be time to think about it now.

Yet in the past the Fed has always raised rates until the economy began to soften. Listening to the speeches from Fed governors, you get the impression they see the statistics we discussed above and think inflation is higher, and potentially going higher, than the lowest estimates suggest.

This is frustrating, as we now have little or no clue as to what the Fed will do after the first of the year. After a long period of knowing the Fed would raise rates by 25 basis points at the next meeting and the meeting after that, we are now left to speculating. We are back to the old world of rumor and innuendo. In a few more months, the markets will start to pay even more attention to data releases, as they look for something - anything - to give them a clue.

I believe Bush should indicate who he is going to appoint as soon as possible, and the Senate should confirm.

Denver, Detroit, New York and Home Again

This weekend Paul McCulley comes into town to visit and watch the New York Giants play the Cowboys. It would have been nice to have our dinner conversation prior to this week's letter, as he is one of the true Fed experts. I will let you know how wrong (or right) he thinks I am next week.

And speaking of dinner, last Monday I had the pleasure of dinner with Charles and Louis Gave (and their wives) in London. They are part of the team that runs GaveKal, one of the information sources I am paying more and more attention to. I invited Bill Bonner, knowing that all I would have to do is say the words "trade deficit" and sit back and watch the conversation get intense. Charles and Louis (along with Anotole Kaletsky) have authored a new book called "Our Brave New World." I have been reading an advanced copy. Basically, they take the position that "this time it's different" knowing full well how loaded with historical fault lines those words have been. Many an economist has foundered on the shores of those words.

Yet, they make an interesting case that the US trade deficit does not matter. But Bill would have none of it. His own new book coming out in a few months shows why it is not in fact different. Each man, armed with recent research and well-honed arguments, stood their ground and fired at will. Your humble analyst got in a few shots of his own Bill was his usual polite self, knowing that someone else was picking up the check. And the Gave's are consummate gentlemen. It was a very good evening. I will recount that dinner and the books in future letters, as the debate over the trade deficit is one of the most important of our time.

I will be in Denver next week speaking Thursday afternoon at the Financial Planners Association. The physical location is at Invesco Field at Mile High Stadium. Most of the attendees will be financial professionals, but it is open by signing up at the above link. Then I will be in Detroit November 3rd and New York the week of November 14-16. After that, I am home for some time.

This last trip to Europe was brutal. I saw too many airports. I was exhausted coming home, but have had a day or two to catch up and feel better. But there were some great moments. We had to drive up to Cheltingham for a few hours through the English countryside, through small villages which had been there for 500 years. It was a perfect day. The leaves were changing and the farms were in perfect order. All was right with the world. There is such a beauty to the English country. It is a place to which I could return again and again, and I will.

At least when I returned to Texas, summer had passed and we are having perfect fall weather. I would like to order about 300 more days like today. And it is the last weekend of the Texas State Fair. Maybe I should visit it. I hope you get out and about where you are, and that your weather is like mine. Enjoy your week. Hopefully, I will not be a good host and the Cowboys will win, but we will have fun in any event

Your getting ready for some football analyst,

John Mauldin
John@FrontlineThoughts.com
Copyright 2005 John Mauldin. All Rights Reserved

If you would like to reproduce any of John Mauldin's E-Letters you must include the source of your quote and an email address (John@FrontlineThoughts.com) Please write to info@FrontlineThoughts.com and inform us of any reproductions. Please include where and when the copy will be reproduced.

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.