Inflation?

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The clock is ticking and we had a good rally yesterday, but we will stay range bound until we get a decision from the Federal Reserve. Their meeting starts today and while Bernanke is still in charge, many will be looking to Yellen’s position as she is expected to take the reins in January. Bernanke’s pull and persuasive abilities with the media, in general, have certainly waned, much like a lame duck President. We are far more eager to hear from his eventual replacement, Yellen, and her views, descriptive words to define the economy, and most certainly her position on monetary policies.


Inflation

One factor the Fed monitors is inflation as measured by the CPI. The Consumer Price Index (CPI) was originally a simple idea of measuring the prices on a fixed basket of goods over months and years. This showed whether general prices increased or decreased and thus determined the rate of inflation. The idea and general method is an important metric, as it determines our buying power, which can be measured against income, yields, and general earnings power.

The CPI, however, has gone through two significant changes over the decades, to such an extent that it no longer actually measures inflation, but rather the Cost of Living. Many will believe there is no difference between measuring “inflation” vs. measuring the “cost of living”; however, that couldn’t be further from the truth.


Courtesy of Shadowstats.com

The general idea for these changes is sound, if one would like to measure how inflation impacts purchasing decisions. However, we can’t assume that by changing the method we are still measuring the same thing.

The major changes to the model were the following: substitution, hedonics, and geometric weighting. Each of these major changes were incorporated based on the argument that REAL inflation is impacting consumer purchasing decisions. Fair enough, but if REAL inflation is actually impacting purchasing decisions and we are changing the model to measure the changes of those purchasing decisions based on Real Inflation, then how are we actually now measuring inflation? It’s a bit of a conundrum.

Substitution
By incorporating these radical changes to the CPI model we are no longer measuring the rate of inflation, but how consumers change their purchasing decision to meet a fixed cost of living. For instance, if the price of steak increases, the consumer will buy hamburger. The consumer is still meeting their needs by purchasing protein (meat); however, one can’t deny that inflation has impacted that purchasing decision. This change is known as the substitution method.

Geometric Weighting
Geometric weighting is when a consumer purchases less of something because the price went up and purchases more of something because the price went down. The item in which the price went up has its weighting lowered as the price of something in which the consumer purchases more has it’s weighting in the index increased. Again, another adjustment to the model based on actual, real inflation.

Hedonics
The last big change was hedonics, this is far more confusing and even most well educated economists can’t give a detailed and sound explanation of how it works. The hedonics adjustment artificially lowers the price of an item in the basket because that item offers an increase in life style benefit. For instance, that new smartphone which cost $300 also allows you to check your email and shop-online, improving your life in some fashion, therefore the government is going to artificially lower the price of that item in the basic cost of goods when measuring inflation.

These changes were adopted in the 1990′s and have made a substantial change to the measurement of inflation. Even the International Labor Organization (ILO) which measures worldwide inflatio, as well as the Cost of Living, has indicated the United States no longer measures inflation, but rather the cost of living. However, the first big change came back in the 1980′s when homes vs. rents were significantly adjusted. As you can see, the changes to the CPI made through the 1980′s and 1990′s( from the way we had measured inflation to now the cost of living) has made a radical difference in the results.


Courtesy of Shadowstats.com

Actually, there is not really a problem with measuring the Cost of Living vs. inflation. The problem only arises when the government tells us it is still measuring Inflation when it is clearly not. In fact, the government has perpetrated a greater fraud by using the words “inflation” and “cost of living” interchangeably while they are clearly not synonymous.

We must also not forget that they are used for determining Social Security payments. Now the government is considering another change to the CPI again and have admitted that the change will help reduce the deficit through lowering the Social Security benefit expense. Clearly the government understands that the CPI has a direct impact on government expenses, regardless what it is measuring.


November CPI

This morning the government released their latest measure on inflation, the CPI shows a rise of 1.2% over the last 12 months through November. If they strip out food and energy, the core CPI rose 0.2%

Of course, this is not really measuring inflation, it is measuring an adjusted cost of living. The people don’t seem to know that and most media pundits don’t know the difference either.


FED TAPER DECISION

Bernanke Yellen

Why is this important? Well, it is one of the chief components of which the Federal Reserve uses to determine their monetary policy. Remember, the Fed has a “dual mandate” to keep inflation and unemployment low. Additionally, the very low CPI, which the Fed uses to gauge the rate of inflation, gives them comfort that their $85 billion dollar a month money printing scheme is not impacting inflation at all.

The CPI data released this morning will get ignored by most, but I have no doubt that the CPI will be heavily discussed in the FOMC meeting today and tomorrow. Yellen and her supporters will use the very low CPI as proof and further justification that we should NOT taper and that the current monetary policy is having no effect on inflation. She could further use the very low CPI to argue that we are not stimulating enough and that we need to create some inflation. Remember, the Fed’s target is 2% and if CPI is at 1.2% there is a long way to go.

Part of the Fed’s money printing scheme (aka QE), is to create a modest amount of inflation. The government and Federal Reserve has huge amounts of debt and one ideological belief among Keynesian economists is that a government can inflate (devalue) their way out of debt.

No nation in all of recorded history has ever devalued their way to prosperity.


Support & Resistance

INDU 15,600 – 16,000
The market made a solid move higher, but now we wait in this range for the Fed to taper or not. Expect some volatility (up or down) on the announcement just a couple of days away.

NDX 3450 – 3500
The tech heavy index is sitting in the sweet spot, waiting to move higher or lower. Expect volatility and a break-out when the Fed releases their decision.

SPX 1770 – 1800
The SPX had a slight bounce, but no really strong follow through. There are more by the day expecting the Fed to taper and that means there is most likely trepidation for getting long this market. The VIX is now above 16 and that means the market is expecting some volatility, perhaps a 2% move at least.

RUT 1100 -1120
The RUT is right at that critical resistance area, which was recently support. I would look at the 1120 area as a straddle strike in which we can see this market rocket quickly away higher or lower once the Fed has spoken.


No Inflation?

Fed Vice Chair Janet Yellen

If the CPI, one of the Fed’s chief economic data points when making monetary policy decisions, shows there is little to no inflation, it is certainly fodder to justify the continuation of QE. In fact, I believe the Keynesian Doves in the Fed could point to the CPI and say we are not printing enough. Well at least the likes of Paul Krugman (NYT economist and Keynesian King) would make that argument.

The CPI gives them cover, or some would say an excuse, to keep the QE going. If we actually believe they make decisions solely based on their “dual mandate” (unemployment and inflation), then they would keep going. Unemployment remains too high, above 7%, and inflation is still too low at 1.2%

Of course I think that is all staged, window dressing and the actual math that no one wants to talk about is that if the Fed doesn’t fund government deficit spending by purchasing government bonds at zero interest rates, then who will? Fed President Fisher pointed out that by now the Fed would be buying 100% of all gross bond issuance.

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