Why the CPI is understating inflation

The big news on the inflation front today is that the 12-month change in the October Core CPI fell to 0.6%, the lowest rate of inflation in the history of the index, which began in 1957. Even the headline CPI was up only 1.2%, which ranks as among the lowest rates of inflation since the low-inflation, early 1960s. To add to the "inflation-is-very-low" news, the CPI index today is still lower than it was in July '08! Yikes, that means we've had over two years of deflation! This presumably makes the Fed governors feel more comfortable with their view that inflation is now "too low" and needs to be pumped up a bit. But with all due respect (a scarcer commodity these days among many reputable economists), I think they are mistaken.

This next chart shows the CPI index less energy, which represents a little less than 10% of the CPI. Since oil prices peaked in July '08, non-energy prices have increased 2.3%, and they have increased despite a wrenching recession and almost a year and a half of 9.5% unemployment. Thus, one big reason the overall CPI is so low is that, since Aug. '08, we've seen oil prices fall by almost half; natural gas prices fall by more than 80%, and gasoline prices fall by 30%. 

The other big reason for low CPI readings is the housing market. As Brian Wesbury has noted repeatedly, one of the key factors depressing the CPI over the past year or so has been the government's estimate of how much rent homeowners would be paying if instead of owning their house they were renting it. If you subtract owner's equivalent rent from the CPI and look just at things that people are actually spending money on, then the CPI would be up 1.5% in the past year. Since owners' equivalent rent is now beginning to increase, after falling from mid-2009 through mid-2010, an important source of lower inflation in the past year or two will begin to add to CPI inflation in the months and years to come. Consider: owners' equivalent rent makes up about 25% of the CPI, is currently unchanged over the past 12 months, and averaged about 3% per year for the 10 years prior to the housing market bubble. If it were to return to 3% a year, owners' equivalent rent could add 0.75% annually to the CPI. 

This next chart comes from a relatively new and very intriguing source, the Billion Prices Project @ MIT (HT: Mark Perry). The chart compares the year over year change in the CPI (blue line) with the year over year change in the price of a basket of millions of consumer-oriented items as priced daily by MIT via online sources. There are some key prices, however, that aren't included, such as energy, cars, transportation, and services such as education, health, and tourism, but those only account for about 40% of the CPI. Despite this, MIT reports a high correlation between their data and the CPI. In any event, the MIT project is reporting inflation of about 1.8% over the past 12 months, compared to the 1.2% gain in the CPI and the 0.6% gain in the core CPI. One more reason to think that the CPI may be under-reporting inflation.

If the MIT index were to include cars, it would be registering even higher inflation, as this next chart suggests. According to the folks at Manheim Consulting, used car prices rose 4.7% in the past year. Since the end of 2009, used car prices have rebounded over 25% to a new all-time high, despite the fact that the economy has not fully recovered, and the labor market is still struggling with 9.6% unemployment.

If there is any deflation out there, it can be found mainly in the energy and housing sectors, both of which experienced a huge runup in price in the years prior to 2008. In my book, that's not deflation, it's pay-back. Almost anywhere else you look, prices are rising.