Solid Foundation for Inflation Fears

After reading the article by Pimco bond guru Bill Gross that Aaron Pressman referenced on Wednesday, I wanted to encourage you to read Gross' comments.

He identifies two issues that bias the government's inflation calculations down. We've talked about one of them extensively on RealMoney: hedonic adjustments.

Some hedonic adjustment makes sense where the calculations are straightforward, and a true comparison can be made between old and new products. That's hard to implement in practice, and easy to inject a deflationary bias into. (Is my computer that is 10% faster 10% better? Probably not.) Often the older goods that are lower in quality aren't offered anymore, so the hedonic adjustment is tough. If I need to buy one refrigerator, it may matter little to me how relatively poor in quality last year's model was if I can't buy it as an alternative today.

Gross brings up a second issue, that of the substitution effect. This is discussed less frequently, but it is still significant. It boils down to the government adjusting the weights in their basket of goods too frequently, so when people buy more of something when it becomes temporarily cheap in relative terms, the government attributes deflation to part of the shift. If the shift reverses and the price rises in relative terms, and people buy less, the government attributes deflation there as well.

A Third Factor

Gross says these two effects end up depressing inflation by 1% annually. A third effect on inflation that Gross does not mention is worth another percentage point, and it is described in an Atlanta Fed paper. The basic idea here is that low financing rates depress the prices on rental housing and used cars. With used cars, when interest rates are low, auto dealers are more willing to offer 0% financing. When 0% financing is offered, used cars are relatively less attractive, so the price of used cars falls in relative terms. With rental housing, low interest rates make the payments from borrowing to buy a home less expensive, thus making rental housing less attractive, leading to a fall in its relative price. Together, used cars and rental housing account for roughly 40% of the weight in core inflation measures, so these effects are material to the calculation of inflation.

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At time of publication, Merkel was long TIPS, though positions may change at any time.

David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

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Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.