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I believe in Santa Claus. I don't believe in the Consumer Price Index. One is a real guy who delivers the goods. The other is a manufactured number that does not.
I've argued before that the CPI is missing heavy undercurrents of inflation, which an abundance of very lively secondary indicators tells us has already arrived in force. Recently, one Fool editor challenged me to identify why those secondary indicators were contradicting the CPI, and investigate exactly what was faulty about this index.
How I know
Before we examine the CPI itself, I'll quickly restate the ways in which the market is telling us that inflation has arrived. Commodity prices are soaring. Companies ranging from McDonald's (NYSE: MCD ) to AmBev (NYSE: BUD ) to United Technologies (NYSE: UTX ) are raising prices. U.S. dollars are falling in value. The stock market is rising. Gold is shooting through the roof. These are the secondary indicators I mentioned, all telltale signs. On the other side of the debate is the Fed, which asserts that inflation levels are significantly less than normal, using the CPI to confirm. Why the disconnect?
A big-picture view
I'm not going to mechanically dissect the government's CPI methodology, because I think most of it is OK. Instead, I'll stick with the big picture and try to focus on one issue. The largest problem with the CPI revolves around its largest input: housing.
More than 40% of the CPI is based on a composite of rent and rent equivalents from major housing markets across the country. That's a very big number for just one item, but the magnitude of the number itself is not necessarily the trouble. It merely intensifies three other underlying problems:
- Fluctuations in housing prices are not shared equally.
- Changes in housing costs aren't experienced in real time.
- Everyone's housing situation is different.
No, Virginia, there is no U.S. housing market
The U.S. has no one single housing market. Instead, it has a fusion of numerous regional and local housing markets. The Bureau of Labor Statistics (the owner of the CPI) is sensitive to this, calculating local CPI numbers in addition to the national CPI number. But the national CPI number gets used to justify strategic decisions on inflation, and therein lies the problem.
If you live in D.C. (as I do), your housing situation is a lot different than that of a person who lives in Cleveland. Yet the national CPI number doesn't think this way. Instead, the disproportionately large and negative pressure on home prices coming from select cities such as Cleveland, Detroit, or Miami is likely to bog down the national CPI number, obfuscating what may be a more accurate and representative figure for people living elsewhere.
That's just one example. The larger point is that housing costs are simply too variable to be captured with one neat number. Real Inflation could easily occur right under the nose of the CPI, simply because there are so many subcurrents in housing prices pushing in different directions.
When do housing costs actually rise?
Our second problem is a bit more abstract. Typical Americans don't experience changes in housing costs nearly as quickly as changes in other cost components of the CPI index.
If you're a renter, you've probably locked in your rates for at least a year, if not more. If you're a homeowner, you're likely to have locked in your mortgage rates for a very long time. You probably won't face fluctuations in home prices again until you're looking to move. Combine that point with another important aspect of housing prices.
If you believe that home prices act as a lagging indicator behind the general U.S. economy (a plausible, but not absolute argument), then you'd sign up for the logic that home prices will only rise after people are convinced that the U.S. economy is healthy again, and after they begin to bid the price of homes up again. All of that takes time -- and we're clearly not there yet as a country.
While inflationary effects manifest themselves more rapidly in other parts of the market (food, gas, etc.), there might be a significant delay before they start influencing housing prices. It's quite likely that the CPI is not fairly representing the real-time inflationary picture because it's being weighed down by much slower-moving housing prices.
What is normal?
The third problem is more contemporary. Thanks to the housing crisis, more and more Americans are choosing to live in nontraditional arrangements. College grads (with and without jobs) are moving in with their parents. Multiple families are living with one another. People are discovering novel ways to deal with housing costs. According to a New York Times article, as of 2008, nearly 50 million Americans lived in households with two or more adult generations. Since then, I'm sure that number has grown.
One important implication of this data is that a massive number of Americans might exist outside the realm of the CPI's effective cost calculations. Plus, what about people who live in homes that are paid off? What about people in government-subsidized housing? What exactly is a "normal" living situation?
Housing costs could easily drop across the board at the same time that many millions of Americans suffer from cost increases in other parts of life. Do these people not feel inflationary pressure, simply because they don't live in what the CPI classifies as a normal housing situation? Here again, I find the CPI's treatment of housing a bit too simple.
Here's the real problem
The CPI appears to treat housing costs as a static, collective experience for all Americans. But the reality is much different. Housing is a beast completely unto itself.
Fortunately, there are collective spending experiences out there. Unfortunately, they're telling us exactly the opposite of what the CPI is telling us.
More appropriate indicators of inflation are the costs that Americans tend to face together, much more equally -- costs like food, gasoline, heating oil, consumer goods, and numerous other everyday expenditures. These numbers are advancing quickly, despite the housing picture.
Fools being Fools
Any index that is 40% fed by problematic information will be at least 40% problematic in its result. Make no mistake: The implications of a poorly calibrated CPI are huge. If the CPI is used to make decisions on topics as important as inflation, and it's not accurately capturing the financial realities of Americans, there's a big problem. I believe housing lies at the root of the CPI's troubles.
I want to hear what others have to say about this issue, so I invite Fools to debate below. Have I got it wrong? Is the CPI working?