You know that statistics lie, but investors continue to rely on some statistics that don't make any sense.
One particularly egregious example of statistics gone wild is the so-called core component of the consumer and producer price index figures. Each month, the Bureau of Labor Statistics releases huge amounts of data on price trends throughout the economy, with the CPI focusing on retail prices and the PPI looking at prices between producers and retailers. Economists tend to focus on two numbers: the overall index, and a core index that leaves out the cost of food and energy.
All too often, these two numbers stand in stark conflict with each other. For instance, in last Friday's PPI release, the overall number rose 0.7%, but the core number was unchanged. Traders took this as a sign that the Federal Reserve would have to lower interest rates, and the stock and bond markets rallied in response.
Sins of omission
How realistic is it to leave out large fractions of the costs that consumers must bear in price index figures? In calculating the CPI, food and energy account for nearly a quarter of the entire index. In the PPI, they account for more than 40% of the index. In the S&P 500, energy companies, including energy giants ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX), make up over 10% of the index. Also, food-related companies such as Hershey (NYSE:HSY), Kellogg (NYSE:K), and Whole Foods Market (NASDAQ:WFMI) make up a significant portion of the consumer staples sector, which composes another 10% of the S&P 500. Certainly, the average consumer would love to be able to leave out food and energy expenses in their monthly budgets.
The argument is that food and energy prices are volatile, and so leaving them out presents a clearer picture of price trends in the economy. However, as a 2005 paper from the Federal Reserve Bank of New York discusses, whether or not using a core index in place of a broader index is useful depends on exactly how you're trying to use the index. The paper points out that as a predictor of future inflation, no core measure does a good job of predicting future CPI levels. And you can rest assured that compared to the core, your own inflation mileage will vary.
If it ain't broke, don't fix it
So why bother looking so closely at core inflation? The answer lies in investor perception of how the Federal Reserve's decision-making process works. The common perception is that the Fed looks closely at core inflation data, especially the index of personal consumption expenditure prices or PCE index that comes from GDP data. Thus, regardless of whether you think core inflation is relevant, the Fed's opinion forces you to pay attention to it.
Nevertheless, it's important not to draw erroneous conclusions from using core price index figures. The underlying assumption is that food and energy shocks are either temporary phenomena or eventually work into prices for other goods. The problem is that if food and energy price changes are temporary, the primary index will be misleading, while if price changes are permanent, then the primary index will lead the core index for a while. Recent experience strongly suggests the latter, as year-over-year CPI comparisons show the full index lurking above core changes during almost all of the past five years.
Not all statistics lie, but they're only as good as the person using them. Understanding the limitations of statistics will help you interpret them more accurately and make your conclusions that much better.
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Fool contributor Dan Caplinger has thought about making his own family price index to debunk government inflation numbers. He doesn't own shares of the companies discussed in this article. Whole Foods is a Stock Advisor pick. The Fool's disclosure policy has no statistics and tells no lies.
