U.S. Inflation: More Than Meets the Eye

Recent statistics paint a rosy picture of the U.S. economy emerging from recession with inflation subdued. Consumer prices, measured by the U.S. consumer price index, are up just about two per cent over the past year, and the "core" rate that strips out food and energy - and is preferred by policy makers as a "more accurate" indicator - is even lower.

But many Americans who do the family grocery shopping, or pays the utility bills, or write a tuition check for their child's education, or use public transportation, or fly across the country knows the truth about inflation.

In my view, the government's consumer price index is seriously flawed and results in a significant underreporting of actual inflation. Today's actual inflation rate is probably four or five percentage points higher than indicated by the reported monthly CPI. Not only is inflation now higher than indicated - but even this official data will show inflation accelerating over the next few years.

Politicians in this country and around the world love inflation because it is a very effective invisible tax that allows a country to overspend, run large public sector deficits, and accumulate debt that will eventually be repaid with debased and devalued currency.

Inflation is a hidden tax that penalises the working poor and middle class whose incomes never rise as rapidly as the true rate of inflation. At the same time, inflation pushes all of us into higher tax brackets (known as "bracket creep" by economists), raises the tax take on gasoline and other excise-taxed expenditures, and pushes up local real estate taxes.

Inflation also penalises creditors - holders of both non-indexed public sector debt as well as private sector debt, who receive back less in terms of actual purchasing power than they lent. Woe to those countries - such as China or Japan - that have financed America's fiscal deficit and now hold hundreds of billions of dollars in U.S. Treasury debt, debt that is losing value as inflation takes its relentless toll.

Inflation is the only politically acceptable method for the United States to dig its way out of today's fiscal mess with trillion-dollar federal deficits pushing total public-sector debt to huge and unmanageable levels.

A country with annual growth in real gross domestic product around one or two per cent and an actual inflation rate of seven or eight percent (a stagflation scenario much like my expectations for the U.S. economy over the next few years) will see its debt go from an unacceptable ratio of sovereign debt to GDP to a ratio that would be deemed acceptable and manageable by the debt-rating agencies in just a few years.

It is easy for the Fed Reserve (or any country's central bank) to raise inflation to accomplish a reduction in the country's debt to GDP ratio. All it needs to do is keep printing money by purchasing government debt -- just as the Fed has been doing in the past couple of years.

But monetary policy is a blunt tool and there is a high risk that inflation won't top out in mid-single digits when the Fed decides enough is enough. It is more likely that the central bank will overshoot - and, before we know it, inflation accelerates into double-digit territory.

The recent inflation measures show year-over-year U.S. consumer price inflation at just over two per cent, and only 1.3 per cent for the "core" rate that excludes food and energy on the grounds that these categories are extremely volatile from one month to the next. Indeed, the Fed and others who influence economic policy in the Treasury, Congress and the Administration prefer this lower statistic even though in the real world consumers do not have the choice to cut food and energy out of their household budgets.

A number of factors distort and bias downward the official U.S. consumer price statistics - and mask serious inflation problems already brewing.

Most importantly, the official statistics are skewed downward by the imputed cost of housing and the impact of falling home prices. Most of us - whether we rent or own our homes, apartments, condos, or co-ops - are paying no less in our monthly rents or carrying costs, but the government accounts for housing costs based largely on the declining "value" of residential housing. As we've noted, the published CPI data for all goods and services puts today's consumer price inflation rate close to two per cent. But the CPI excluding the cost of housing is already rising by more than four per cent.

The U.S. consumer price index since 1990 has not been based on a fixed basket of goods and services. Instead it allows for substitution from more expensive purchases (like sirloin steak) to less expensive purchases (like chopped chuck steak). By doing so, it decreases the weighting of those goods and services with more rapidly rising prices and increases the weighting of those items whose prices are rising more slowly or possibly falling.

In addition, the CPI is adjusted downward to account for qualitative improvements in the goods and services we purchase. For example, a typical mobile telephone last year may have cost $200 and today's standard model may now cost $220 - a 10 per cent increase. But because it has a better screen and longer battery life, government statisticians may judge the improvements to be worth $20 and record the price as unchanged, rather than up ten per cent, for the purpose of calculating the CP.

Taking these factors (substitution of higher priced goods and services with lower priced items and factoring out downward adjustments due to qualitative improvements) out of the calculation of the consumer price index results in an inflation rate several percentage points higher than indicated by the official data reported by the statisticians in Washington.

And one more thing, consumer prices have also been temporarily depressed by the economy's cyclical inventory adjustments, as cost pressures already in the pipeline have not yet been seen at the consumer level. Many businesses have been living off inventories of raw materials and semi-finished goods bought earlier at lower prices - and prices of finished goods at retail reflected these lower priced inputs. In this year's first quarter many businesses began restocking and replenishing of inventories at higher prices, higher prices that just recently have begun to be passed on to retailers and consumers.

© 2010 American Precious Metals Advisors

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