No Inflation?

Talking heads in the financial sector seem quite fond of crowing about how well the economy is doing. One metric they never fail to point to is the Consumer Price Index, a primary indicator of inflation. It invariably shows that we’ve got the perfect amount: approximately 3% per year.

Does that make sense to you? Now keep in mind I’m not a doomsday guy. I think the long terms prospects for our country are bright. But the focus seems to be on the short term right now, and that might lead to some serious pain in between.

From where I sit, it seems the vast majority of an average American’s income goes toward housing. Home prices have been on an exponential rise for half a decade. The cost of higher learning has outpaced the mythical inflation figure for more than 20 years. How about health care? Have your costs been rising faster than 3% per year? Mine sure have. And the energy sector — been to the gas pump lately? I rest my case.

So the question is, why aren’t these hard cold facts reflected in the CPI? Answer: because the CPI doesn’t measure these things properly. In some cases, it doesn’t measure them at all. As Fortune puts it:

What’s more, real-life inflation may be much worse than the official statistics indicate. Take a look at the CPI’s methodology. Its statisticians make use of “hedonics,” a method of attaching a value to the increase in the quality of new goods. Here’s an example: If your new computer cost $500 more than your old one but had more than $500 worth of improvements (according to Treasury wonks), the CPI says it actually cost less. The sticker price for a car bought in the U.S. has risen 338% since 1979, according to the Leuthold Group, an economic consultancy. But because of hedonic adjustments, the CPI reflects only a 62% rise.

Another curious thing about the CPI is that it does not calculate changes in housing costs by the sales prices. Instead it uses a figure that estimates what homeowners would get if they rented out their homes. In 2004, national housing prices rose more than 11%, but the CPI calculates that they rose about 2%.

For a long time this was just a funny factoid. Now it’s a real problem. Incomes are not rising nearly as quickly as expenses, which means many of us are getting poorer without realizing it. Or perhaps we simply refuse to admit it. Either way, it’s clear that something is out of whack. It’s even stumping the Federal Reserve, whose governors are scratching their heads over a yield curve inversion that now has short term rates above long term ones. To me, the inversion’s cause is clear: the market is trying to return to equilibrium but it can’t because the low cost mortages are keeping long term rates artificially low.

Once the true scope of inflation becomes clear, long term rates will have to adjust upward as investors demand higher returns on their money to account for the dollar’s decreased buying power. Higher rates will crush the housing market and lead many with what I generously refer to as ‘questionable’ loan products to the sellers table. Even if they don’t want to sell, dramatically higher rates combined with high principal balance adjustable mortages will make it inevitable.

Lest you think “ah–buying opportunity!”, by this point underwriting standards will have tightened and buyers without large down payments (remember the days when 30% was customary?) won’t be able to get a loan, especially if the property in question is not a primary residence.

The government-backed mortgage holders like Fannie May will be stuck with a sagging multi-trillion dollar portfolio of underwater mortages and outright defaults. And it’s at this point that lawmakers will realize that perhaps allowing anyone and their grandmother to dump subpar loans on the government might have been detrimental to underwriting standards. Laws will change, but it won’t be enough to keep the economy afloat since the home equity cash cow will have long since shriveled up, taking consumer spending along with it.

The stock market tanks, job losses balloon, home prices fall, consumer sentiment sinks, and you have all the makings of what could be the next Great Depression. At best, we’re in for a recession which will make the 2001-2004 malaise look like a picnic.

Think I’m crazy? Go ahead, make your case.

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