CPI, Inflation, and the Government Affair

Ahhh, the Consumer Price Index. The CPI is one of the most frequently referenced and utilized data in economics, finance, and politics. Because the index depicts the overall cost of our living, it provides a very crucial pivot for economists, producers, investors, and policy makers. Considering this significance, a careful look into the government index is warranted.

The headline CPI consists of a variety of categories. Food and energy costs weigh in for roughly 23% of the index, while housing cost (CPI - Shelter: rental equivalence approach) makes up 22% - the single largest component of the headline CPI.

From the Bureau of Labor Statistics:

Until the early 1980s, the CPI used what is called the asset price method to measure the change in the costs of owner-occupied housing. The asset price method treats the purchase of an asset, such as a house, as it does the purchase of any consumer good. Because the asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons, the CPI implemented the rental equivalence approach [OER] to measuring price change for owner-occupied housing.

What do they mean by "inappropriate results?" Looking at the graph above (posted here, thanks to contraryinvestor.com), one can see that the new OER method (CPI - Shelter) did not diverge much from the original asset price method until roughly 2000. Since then, however, the current method has failed to reflect real housing price inflation. Moreover, only 30% of the US population rent homes, while more than 60% currently own homes. People not only own homes (through mortgage loans), but they also borrow against their homes (against their mortgage loans) to buy even more homes! The CPI's disconnect from reality is exacerbated further by mainstream reliance on the supposed "core" CPI, which strips food and energy costs from the headline CPI. Ultimately, the core CPI fails to reflect nearly 50% (OER + no food and energy costs) of prices relevant to consumers. Clearly, the BLS does not believe this to be an "inappropriate result."

Similarly, the Fed seems to be turning a blind eye to the CPI's shortcomings, not to mention the incessant growth in M3. This tells us that bond investors are also not discounting for real inflation, thus keeping long term yields low. Of course, we do not expect this "conundrum" to continue forever. Seeing that the Fed's current interest rate hikes are not able to curb money supply growth (assuming M3), we expect the economic reality of inflation to dawn upon the market before long.