The Truth About Inflation

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As recent debate on the pages of this Web site has shown, there is a divergence of inflation views. There's plenty of misinformation and spin out there, too.

I believe the economy is experiencing robust inflation, and has been for some time. While energy certainly is a part of that -- crude oil has run from $25 to as high as $70 -- inflation is not just confined to energy.

What Is Inflation?

Inflation is the rate of increase in general prices of all goods and services. It also can be described as a decrease in the purchasing power of money.

Regardless of your definition, inflation occurs when goods and services cost you more than they did previously. As this happens, your money becomes worth less than before.

How Is Inflation Measured?

The Bureau of Labor Statistics uses a basket of goods and services to measure inflation from both the consumer (CPI) and producer (PPI) perspectives. The basket includes: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services, including tobacco, haircuts and other personal services.

I have been critical of the way this basket is constructed and measured. First, it does not adequately reflect how people in the real world experience price increases. Second, permutations, substitutions and hedonic adjustments further distance CPI from the real world. In several categories, the BLS massages the data beyond any correlation to reality.

Torture data long enough, and it will confess to anything you want it to.

The So-Called Core

Speaking of torture, the CPI core is a measure of inflation with food and energy removed. By taking out the more volatile elements, economists ostensibly avoid having a single outlying month disrupt an orderly data series.

More numerically literate observers might think a simple moving average would do the same thing. It would reveal when prices are rising, while smoothing the impact of one-time price spikes. Yet this is not how most economists report CPI. One has to wonder why they have been reporting inflation data excluding energy 48 months into a robust move upward in oil prices. That hardly looks like removing a one-time "outlier."

The CPI ex energy measure is misleading, as it makes inflation appear far more benign than it really is. But don't think it's just energy; lots of other items have also risen in price.

The CRB Index, for example, has been in a strong uptrend since October 2001. Yet despite all these rising prices, the core CPI rate has remained remarkably stable.

In addition to energy and other commodities, education expenses have outpaced median inflation, as have health care costs.

But the biggest factor not reflected in the CPI basket is the cost of housing. Home prices have gone up dramatically -- the National Association of Realtors' Housing Affordability Index is now at 14-year lows. But you cannot tell that from the CPI.

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Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback; click here to send him an email.