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Measuring CPI Inflation, Alice In Wonderland And The Bond Yield Paradox

Economics / Inflation Oct 10, 2009 - 02:01 PM GMT

By: Andrew_Butter


Diamond Rated - Best Financial Markets Analysis ArticleThis article is not about what inflation is, it's about how you measure one component, CPI (Consumer Price Index), there are other components; but that's the focus of this article.

Big picture to estimate CPI you work out a "basket" of goods and services that consumers buy which you think is representative of the structure of spending in an economy, and you do a survey, then you compare that with how much it would have cost to buy the same "basket" a year before.

For example in USA in 2008, the "relative weight" of what is called the "Owner's Equivalent Of Rent" (OER) was shown as 24.4% of the "basket", according to the survey it went up by 2.5% so that means that part of the basket contributed 0.611% to "inflation" as recorded in the final CPI figure put out by the Bureau of Labor for 2008.

Of course the owners of houses didn't actually pay "rent" to themselves; that was not a transaction that could be audited because it never happened, or not like that anyway. It is a "record" of a transaction that "might" have happened, but did not happen.

If you feel uncomfortable that 24% of a major benchmark used for making economic decisions in USA is reliant on a "measurement" of something that might have happened, but didn't, well you "might" have good reason to be.

The Mad Hatter in Alice in Wonderland would be proud, and you wonder why there is a credit crunch?

Reality Check
What did happen was that the owner deployed a certain amount of money to own the house and the deployment of that money had a cost.

By convention, the cost of financing that deployment of money is not considered relevant to CPI, nor is the loss or profit in terms of investment considered. In other words, the fact that the owner might have borrowed 100% LTV and be paying a punitive interest rate, and/or might have lost half of his "investment" over the course of a year, is considered to be irrelevant insofar as CPI is concerned. Whether that makes sense or why, is not the subject of this article, that's just the way they do it in USA (in UK they do it different, in Germany they do it another way, which makes comparison of CPI between countries another venture into Alice's secret garden).

Anyway, reality; the cost to the owner was (a) the mark-to-market value of the house at the beginning of the year (the price he would have paid if he bought it then), multiplied by (b) the cost of deploying that money, which is often considered to be the yield of a long-term risk free bond (i.e. for example the 30-Year US Treasury).

For the sake of argument lets use that, we could use the cost he pays for any debt that he has, or some other marker; I read that recently an eminent economist was commissioned to compile a list of the top 100 economic theories currently in vogue in USA, he was having a problem keeping the list under 100; I'm sure there are at least 100 theories on what is the cost of deploying those funds, and they are all different, like a Mad Hatter's riddle. And you wonder why there is a credit crunch?

But one thing is for sure, the issue is not what the owner "might" have done with the interest he could have got if he had not owned the house, he "might" have put it in the bank and walked across America, he might have gone and lived in a cave in Toro Boro; there are so many options. The point is he didn't do whatever he might have done.

That "interest" that he could have got, is what the owner DID spend, not what he MIGHT have spent. That is the number which should properly be recorded in the calculation of CPI.

I shall call that the "Owners Cost of Money" (OCM).

Reworking CPI to account for OCM.
Assuming for a moment that the measurement of that component of the "shelter" component of CPI is the only major error, this is a reworking of CPI in USA since 2000 substituting OCM calculated that way for OER.

That can't be right!
It says deflation started late 2007 and in 2009 CPI will end up about MINUS 6%.

So who's the Mad Hatter then? 

Perhaps it is me? When I wrote in May that there would not be a serious reversal of the Dow until it hit 10,000 (which it did 1% ten days ago), a comment I got on Seeking Alpha was "this is the dumbest article I have ever read", but then perhaps sometimes it's better to be "dumb" and "mad" than wrong? Evidence the credit crunch.

Could it be that 100 PhD economists in the Bureau of Labor overlooked something as simple as that? Could if be that half a million economists around the world can't even figure out how to work out CPI properly? That can’t be right, of course not!

That sounds insanely far-fetched, although there again, none of them realized there was (1) a gigantic housing bubble and (2) that would blow up in everyone's faces…apart from a few, but they didn't manage to persuade any of the other economists, and anyway by then it was too late.

But logically, they have to be right, third time lucky!

It stands to reason, if the 100,000 or so economists employed by the American Government (and paid by the American taxpayer) can't get anything right, then what's the point of employing them?

How about a check? Every bond dealer knows that the yield on a 30-Year Treasury is a bet by the invisible hand of the all-knowing market on inflation in the future; predicated to some extent by inflation today.

So a plot of the 30-Year bond yield (I'm using annual averages) against either CPI-U or CPI-OCM ought to be able to shed some light on what is "real" and who is the Mad Hatter?

Well neither estimate is a great predictor of the yield on the three 30-Year, although CPI-OCM is three times better than CPI (and no, sadly, lagging, projecting the future, etc doesn't change that, I checked).

That suggests CPI-OCM which explains 38% of changes is probably a better measure of reality, as opposed to a measure of what might have happened, but didn't, which explains only 13% (and if you take out 2008 it's about zero which means there is absolutely no correlation at all).

So either the notion that the yield on the 30-Year has got something to do with inflation is just an old wives tale, like for example, Ben Bernanke's and Hank Paulson's rosy projections made in 2007 and 2008 about what "might" happen in 2008 and 2009, but which in fact didn't happen, or CPI-OCM is a better benchmark for reality.

The Paradox:
If that's right (or half right - there are other issues (see, then the dynamics of what happens to house prices will affect CPI.

Again the issue is not how much a significant proportion of the US population might have lost betting that house prices would go on going up forever, it's how much a house would fetch if you wanted to sell and take the money and walk across America, and what you would get for parking that money somewhere safe.

I have argued in previous articles that the price of housing in USA for the next three years will be predicated by the level of mispricing that happened before (

The exact bottom will depend mainly on how nominal GDP holds up (the better that is the higher the bottom), plus to some extent (a) long term interest rates (b) steps taken by the government to channel money/debt directly to the "coal-face" to tide ordinary people over the inevitability of the "over-shoot", rather than handing it out to their cronies on Wall Street.

But broadly the general dynamic is pre-destined (

By the same token, the "conventional" tactic of dropping interest rates to stimulate growth, won't do anything unless (a) banks start lending and (b) people want to start to borrow; and if deflation is on the table, which appears to be a fact of life out on the streets (regardless of the elegant arguments of "velocity" (typically calculated by reference to CPI although many forget that small point)), for ordinary Joe The Plumber borrowing more in the current environment is lunacy.

Getting people to "borrow and spend" right now is not about what interest rate they pay (and any margin on the base rate in any case is swallowed by the Zombies), it's about them having confidence that the amount they have to pay back in the future won't be a lot more in real money than what they borrowed, which is what happens in deflation.

It's all very well to cite Keynes, but right now the only way to get money moving around the economy faster is to stand on street corners handing it out, like "Cash for Clunkers" and the $8,000 hand-out to first time buyers. And that's a lot more efficient than waiting for the "trickle-down" from building underpasses for turtles in Florida.

Sure opening a credit window and other mechanisms to force-feed incompetent banks money like so many geese being fattened up for Paté de fois-gras, "saved the banks" and more important forestalled a cataclysmic unraveling of the $50 trillion plus or minus (no one knows how much exactly) CDS market (

Which was what Martha Stewart would call a "good thing".

But if the economists who (1) couldn't recognize a housing bubble until it slapped them in the face (2) couldn't predict what would happen when it unraveled (3) (according to me) can't even measure CPI properly, are predicting that taxpayer-funded largesse will "save the world", well all I can say is they don't have a very good track record.

In Japan after their housing bubble that's what they did, they dropped the base rate to zero which helped the Crony Zombie Banks "earn" their way out of trouble on the yield curve, they did un-stressful "Stress Tests" (just like Geithner did - it's called forbearance), and they built bridges to nowhere (this time they will tag sage grouse and build underpasses for turtles); but it did nothing to stimulate the economy, and the banks didn't lend except at exorbitant rates - there was no reason they should. That resulted in an "L".

House prices are broadly pre-destined; little can be done to alleviate the suffering that was caused by a massive failure in economic theory and regulatory oversight. What can be done is:

(1): Increase interest rates to INCREASE inflation. That sounds contrary to every one of the 100 theories of economics that are currently in vogue, but just because they are in vogue doesn't mean they are right, evidence the credit crunch.

The time for slashing the base-rate to 0% was September 2007, that moment has passed, the crisis was not averted, and all that the economists can say is "without us it could have been worse", some consolation. But now fighting yesterdays wars will be as futile as building the Maginot Line.

(2): Stop throwing money you don't have at Zombie Banks. That money is being used to pay for past incompetence and gross negligence, apart from the moral hazard; it's not getting through to the economy in general.

It does not make any sense to support banks that cannot (a) support the economy (b) figure out a way to be profitable. In any case many of the "services" that they provided in the past were "socially useless", by their own admission (

(3): Pass a Federal Law that mandates anyone who willfully allows a bank or financial entity to trade insolvent to be prosecuted as a common criminal. I thought there was a law against that, evidently there is not. Too many people have got away with too much, there needs to be claw-back of ill gotten gains, just like with drug dealers; and the bankers did far more damage to the fabric of America than the crack cocaine drug dealers ever managed.

(4): Value bank assets using International Valuation Standards. Until there is a reliable way to measure the value of "assets" held by banks, everyone is sailing blind.

(5): Learn to live with the pain, stop taking painkillers; they are addictive. A bust is a process, industries and businesses that could only be profitable thanks to a bubble go to the wall, that hurts, but supporting such industries damages the viable ones. And no, creating another bubble so that which cannot survive without the drip feed of government incompetence, prospers, is just Alice in Wonderland talk.

(6): If the "bleeding hearts" want to do "something" increase unemployment benefits and accessibility to medical care to people who lost their insurance, i.e. help the victims of the last great economic theory to hit the dust (whatever it was - I think they called it "inflation targeting", which is a great idea when you can't even figure out where the target is). If all the economists in USA couldn't see the madness, how was ordinary Joe Plumber expected to?

That's money out on the street for people to spend, just like cash for clunkers, except that gets to the people who really need it. And that doesn't have to be thought of as completely altruistic, the option is they steal it.

(7): Get out of the kitchen and let the free market heal itself.

Perplexing times.

It's unlikely the government will do any of that, in which case, assuming:

(1): House prices have another 10% to go.

(2): The 30-Year will be up to 4.5% by early 2010.

(3): "Non OER" CPI will be more than 1% in 2010.

Then by this model the end of 2010 the 30-Year should be about 5%, what happens next will depend on how improvident or incompetent the US government is over the next year, don't hold your breath (evidence the credit crunch).

On reflection I think this is a more valid argument than my previous argument that set a target for the 30-Year of as much as 7.5% which was probably over-the-top, mainly because I didn't realize how much money is still coming into USA from abroad, plus remittances of foreign workers are down  (

By Andrew Butter

Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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