Live by the "core,"
die by the "core"
May 20, 2006
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 overdue 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 a large part the result of 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
opposed 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
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.
Now that reality is beginning
to set in, time is running out to get out of the dollar. Protect
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C.E.O. and Chief Global Strategist
Euro Pacific Capital, Inc.
Mr. Schiff is one of
the few non-biased investment advisors (not committed solely to
the short side of the market) to have correctly called the current
bear market before it began and to have positioned his clients
accordingly. As a result of his accurate forecasts on the U.S.
stock market, commodities, gold and the dollar, he is becoming
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In addition, his views are frequently quoted locally in the Orange
Mr. Schiff began his investment career as a financial consultant
with Shearson Lehman Brothers, after having earned a degree in
finance and accounting from U.C. Berkley in 1987. A financial
professional for seventeen years he joined Euro Pacific
in 1996 and has served as its President since January 2000. An
expert on money, economic theory, and international investing,
he is a highly recommended broker by many of the nation's financial
newsletters and advisory services.