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Easy Al's 1% Wonder

Why the CPI Matters

So before you bet the farm on the accuracy or fairness of the core CPI report, remember some of these factors. They remove food and energy prices. They fabricate the largest component, housing costs, from an indecipherable concept, owner's equivalent rent. And they adjust for quality the base pricing of many other components to mitigate actual price changes in goods and services. You see, prices are not really increasing; everything you consume is "improving." Talk about fudging the numbers! In my opinion, a 1% inflation rate today is as mythical as the "New Economy" of the last bubble. Unfortunately, market participants have bought into it just as much.

Why does the CPI matter, you ask? A low CPI does keep cost-of-living adjustments lower and helps with the government's budget. Well, it matters very much if you use the concept of low inflation to justify a fed funds rate of 100 meager basis points. It matters very much if the government wonks insult our collective intelligence with spin and deceit. As we experienced just a few years ago, it matters very much if the financial markets value cash flows with artificially low discount rates. It matters very, very much when that 1% rate normalizes back to 4% or 5%. But for today, that understated CPI justifies Easy Al's "1% Wonder."

That 1% fed funds rate sets the stage for T-bills and much of the rest of the yield curve. It also drives economic activity higher than it would be otherwise. In my opinion, this 1% Wonder has really kept the whole economy and the financial markets together! But it comes with a price.

With cash and fixed-income rates so low, many kinds of imbalances are created. Unnaturally low interest rates dissuade savers and forces investors out on the risk curve. Savings rates plummet. Asset prices increase, and speculation builds.

You can see this in 2003 performance: With cash forced from the sidelines, all major asset classes -- stocks, bonds, commodities, raw materials, collectibles, etc. -- appreciated significantly. Financial leverage also increases as investors attempt to gear lower nominal returns. This sets the stage for a more disruptive reliquification process when rates do return to normal levels.

Those unsustainably low interest rates also affect the real economy by stimulating the housing and durable goods markets. Much of the strong economic activity over the past few quarters can be tied to deficit spending and increased consumer borrowing. Zero-percent auto loans, minimal equity and interest-only mortgages are a product of this rate environment.

With real income growth rates at their lowest levels in a long time, consumers have once again turned to asset monetization and leverage to support current consumption. The million-dollar question remains the sustainability of this type of demand. Or will the inevitable increase in interest rates initiate a vicious cycle of lower asset pricing and consumer retrenchment?

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