Mortgage News & Commentary - It's Inflation Stupid

By
Dick Lepre Residential Pacific Mortgage

It's Inflation Stupid

December 22, 2006

We can talk about what the Fed is doing and what yields are doing or going to do but when all the shouting is done it is all about inflation. The underlying reason is quite simple. The folks who buy fixed income securities: Treasury debt, corporate bonds and mortgage backed securities (or parts thereof) are people who already have a lot of money. If you are wealthy you are really not concerned about acquiring more money than you will ever be able to do anything with you are concerned about preserving the purchasing power of your present wealth.

For such a fortunate person the investment of choice is some sort of bond and the sole enemy is inflation. Thus, yield on bonds move with inflation or, more correctly, the perception of inflation.

The Measures of Inflation

Inflation is well-contained. By "inflation" we are almost always talking about CPI. But, there are other measures of inflation. Some of these are more forward looking than the backward looking, "this is what happened last month" nature of CPI.

Consumer Price Index (CPI)

CPI is a measure of the average level of prices of a fixed "market basket" of goods and services purchased by consumers (food, clothing, utilities etc.). CPI is an indicator of inflation on the retail level.

This is calculated every month by the Bureau of Labor Statistics and available online at http://www.bls.gov/cpi/

The are 2 major CPI's:
CPI-U (U is for Urban) which represents about 80 percent of the total U.S. population. It is based on the expenditures reported by almost all urban residents, including professional employees, the self-employed, the poor, the unemployed, and retired persons as well as urban wage earners and clerical workers.

CPI-W is based on the expenditures of urban households that meet additional requirements:
More than one-half of the household's income must come from clerical or wage occupations and at least one of the household's earners must have been employed for at least 37 weeks during the previous 12 months. CPI-W represents about 37% of the population.

It is the CPI-U which everyone (including me) calls "CPI".

CPI includes:

Food and beverages (cookies, cereals, cheese, coffee, chicken, beer and ale, restaurant meals)

Housing (residential rent, homeowners' costs, fuel oil, soaps and detergents)

Apparel and its upkeep (men's shirts, women's dresses, jewelry)

Transportation (airline fares, new and used cars, gasoline, car insurance)

Medical care (prescription drugs, eye care, physicians' services, hospital rooms)

Recreation (newspapers, toys, musical instruments, admissions);

Education and communication (tuition, postage, telephone services, computers);and

Other goods and services (haircuts, cosmetics, bank fees)

CPI is seasonally adjusted to cull apart the changes that are seasonal from the underlying economic changes. Seasonal changes are fluctuations in prices that occur at the same time very year. They might be due to: automobile model changeovers, weather and holidays. For example, gasoline costs more in the summer, tomatoes cost more in the winter. An interesting issue at present -when inflation is tame - is that the question may well be: are we actually measuring inflation or are we measuring the accuracy of this months seasonal adjustments?

The unadjusted data is what people actually pay. The adjusted data is what is reported in the media. CPI is a number that reflects prices with 1982-1984 averages as 100.0. The percentage changes announced month-to-month are adjusted so as to be a percent of the value of the last month's index.

CPI is based on a very large sample of goods in a very large sample of places. The one criticism that can be made is that it takes no account for what people actually buy. If, because of El Nino, tomatoes which cost $1.39 a pound in March now cost $4.59 a pound, people will diminish their purchases. Because of this, CPI is, in terms of what people actually buy, slightly overstated.

PPI

PPI is the Producer Price Index - this measures the average change over time in the selling prices received by domestic producers of goods and services. PPI's measure price change from the perspective of the seller. This varies from CPI this is a measure of price change from the buyer’s perspective. Sellers' and buyers' prices may differ due to subsidies, taxes, and the dynamics
of distribution costs. They also are affected by the "depth" of competition of the marketplace.

Implicit Price Deflator

While CPI might be the "Dow" of Inflation it is, in essence, a measure of the price that people pay for things and services. The economy, however consists of a bit more than individuals.

A broad measure of economic activity is GDP (Gross Domestic Product). The GDP Implicit Price Deflator or IPD is based on the Gross Domestic Product and therefore reflects price changes in all goods and services transactions in the United States, including the consumer, producer, investment, government and international sectors. The IPD for GDP takes into account
the price changes of the goods and services that actually happened. The IPD for the GDP is, thus, a more meaningful measure of inflation than either CPI or PPI.

IPD might, for example, be used to adjust the cost of a long term projects such as Civil Engineering projects. The EPA, for example, writes it into the bids for toxic cleanup projects. If one wanted to compare the economic impact of natural disasters from different periods, it would be appropriate to normalize the dollar losses at the time that the occurred using IPDs rather than CPIs.

ECI

ECI is the Employment Cost Index. When we were hearing about a tight labor market this might be where inflation would first show. ECI is the cost of labor on a fixed basket of occupations. This eliminates the effect of the influence of employment shifts among occupations. While the average hourly earnings data would be affected by a shift in the occupational composition of the workforce and would appear as a wage gains, ECI would not be affected. Wages & salaries account for about 72% of the ECI. The rest is benefit costs.

Data is available from BLS at:
http://stats.bls.gov/news.release/eci.t01.htm

FIG

FIG is a product of Economic Cycle Research Institute, Inc. This is a construct that is forward looking. It is a way to predict future inflation. The previously discussed indices take note of inflation that has already occurred. ECRI has a WWW site at http://www.businesscycle.com

This site is a, sort of, Bible on inflation. FIG is reputed to be able to predict inflation up to a year ahead.

.

Dick Lepre
Mortgage Broker and guest writer for CompareLenders.com

Guest writers do not neccesarily reflect the opinions and views of CompareLenders.com / SBBNet, Inc.
All information is based on information believed to be accurate but we make no guarantees.