Berkshire Hathaway
Incentive Caused Bias

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By rclosch
January 24, 2006

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Mistermarket asks

"I'm interested in opinions about whether it is possible that inflation is actually occurring as we post comments here, meanwhile per adjustments (and exclusions) in the method of calculating inflation, the old man-created fiction seems to be benign."

Figures for the CPI in October show inflation at a 15 year high of 4.7%. The FED, of course, prefers the core rate that was up only 2% year over year, but even 2% is considerably more than zero. It is interesting that consumers do not seem to agree with Greenspan's assertion that "inflation properly measured is near zero". The University Of Michigan Survey Of Consumers shows consumers inflation expectation at 10 year highs.

Perhaps more significant is the fact that the FED itself does not seem believe either. If inflation is zero how can a FED funds rate of 4.25% be considered neutral?

Personal Consumption Expenditures

The CPI measures a theoretical market basket of goods and services, but if we look at how we actually spend our money and attach an inflation rate to some individual components we get a very different picture than the one presented by the CPI.

According to figures from Bureau of Economic Analysis, Personal Consumption Expenditures at the end of the third quarter of 2005 were running at an annual rate of $8.84 trillion. Of that total housing at 1.28 trillion was 12.8%, energy expenditures were $.54 trillion or 6.1%. Medical care was $1.52 trillion or 17.2% of personal consumption expenditures, and food was $1.23 trillion or 13.9%, the total of these 4 items was $4.58 trillion and they amount to 51.8% of all the money spent by American consumers last year.

Published reports so far indicate that housing prices increased by 12%-13% last year, health care by something like 7.6%. Energy costs by17% and food by 7.7%. If I add these figures together and take an average this 51.8% of our spending experienced inflation at a rate of 9.4% last year.

So yah, I do have trouble with the math that Greenspan uses to get inflation to "near zero".

Incentive Caused Bias

Would the government publish statistics that it knew to be wrong? Maybe not, but my guess is there is at work here a serious case of what Charley defines as "incentive caused bias". The best interest of pretty much every one inside the Beltway is served by low inflation. It keeps the cost of indexed programs such as social security low, and it keeps the cost of servicing debt cheap. With $8.1 trillion in national debt, interest on that debt increases by $81 billion for each one percentage point increase in interest rates.

If inflation is running at 4.7% an interest rates on government securities are 5% then holding government debt is an act of charity but one that I am sure everyone in Washington would like to encourage, If the cost of carrying that debt goes up the deficit will increase faster. This is not going to make it easier to get re-elected.

At the same time there is a positive side to inflation for a debtor, the real cost of the debt is reduced because you get to pay off the debt with cheaper dollars. Today our Government is the biggest debtor in the world and has the better of two worlds. The cost of paying off that deficit is declining because of inflation; and low interest rates make the debt cheaper to carry.

So are the bureaucrats going to complain? Are the politicians going to scream for reform of the data to gives us more realistic gauge? Don't hold your breath.

Munger and Buffett keep saying that the Markets are mostly efficient but that the difference between mostly and completely is big enough to make a lot of people rich. The reality, of inflation is simply not priced into this market for either equities or long bonds. Both these Markets seem to assume that inflation will continue in the trend of the last twenty years. If it does not, it may present us with a soft pitch

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