Easy Al's 1% Wonder

If things aren't vastly different this time, an adjustment to more normal levels could be painful.
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Yet again, the Fed Chairman reinforced the concept of the "Greenspan put" with Tuesday's FOMC announcement. The fed funds rate will remain artificially low for as long as necessary. Go to it!

Investors, pile on the carry trade or buy some beta. Consumers, go refinance the old homestead for a third time, extracting an extra 10 grand for that Caribbean vacation you deserve. Or dump that 3-year-old SUV for a brand spanking new Hummer.

We have evolved from a manufacturing economy to a service economy to a finance economy, where people can borrow and spend their way to prosperity. You see, inflation is negligible and those 0.50% money rates implore you not to save. It all sounds fine, except for the fact that inflation is not quiescent.

I know, I read the paper like everyone else. The government says that the consumer price index is some low number like 1% or 2%, and the risk of menacing deflation is a legitimate concern. The government would never fudge something as important as the CPI, would it? But that number just doesn't smell right.

Where's the Deflation?

Most of the goods and services I consume seem to be escalating in price by much more than a percent or two. My tuition bills, health care premiums, insurance costs, transportation and energy costs, home-operating expenses, are all increasing at high-single-digit or maybe even double-digit rates. Home prices in my neighborhood are skyrocketing. As for entertainment, the restaurant check, the movie tickets and the cable bill have all jumped much more than a couple percent. Deflation here? Give me a break.

With my personal inflation experience so much different than government statistics, I decided to research the CPI. Here's what I discovered. First, the government removes food and energy, about 22% of the index, when calculating the core CPI. I guess if you don't eat, drive or heat your home, this would be appropriate.

Next are housing costs. This is the biggie, weighing in at about 40% of the actual CPI and closer to half of the core index. Now, everyone knows that housing prices and operating costs such as insurance and taxes have appreciated strongly in the past few years, something like 5% to 7% annually. Clearly this component must be pushing up the inflation numbers. Well, not really. The government doesn't use housing prices and home-operating costs, but rather a quite interesting concept called rent and owner's equivalent rent.

An overbuilding of apartments and a secular shift toward home ownership have depressed the rental market. About 70% of households own homes today and are not directly impacted by rents. However, the government doesn't revert to actual housing costs here. Instead, it attempts to estimate what homeowners' rent would be if they were renting their primary residence.

But very few single-family homes participate in an active rental market. So, basically, the government makes it up. In the December 2003 CPI report, the total rent component of the CPI (rent plus owner's equivalent rent) rose 2.2%, a 20-year low. Even adjusting for lower financing costs, I have a difficult time believing that 2.2% number, as does my real estate agent.

But it gets even better. When energy prices increase significantly, as they recently have, shelter prices decline. That's because the rent/owner's equivalent rent concept implies a heating/cooling contract. Because actual rent paid is somewhat sticky, rising energy costs decrease the value of the rent component. For example, the housing part of the CPI was up 2.1% in February year over year. But in the core CPI, spiking energy costs lowered the change to 1.6%. With this methodology, $100 for a barrel of oil would turn the rent/OER concept negative in and of itself. How absurd is that?

Jim Grant, proprietor of

Grant's Interest Rate Observer

, has calculated the CPI substituting a housing price index for owner's equivalent rent. As his chart reveals, inflation is running around 3.5% instead of the 2.2% core number reported by the government. This kind of number seems more accurate to my personal income statement.

A Different CPI Perspective
Here's what it looks like with real housing prices

Source: Bureau of Labor Statistics, Freddie Mac

It gets even better. The people at the

Bureau of Labor Statistics

make qualitative adjustments to goods when they perceive improvements. That is, they adjust the base price of a good or service upward due to quality improvements. This action then understates the increase because of price inflation of the good. The BLS does this with more than 50% of the CPI components!

They do not, however, adjust base pricing lower for qualitative deterioration in a product. Steve Leuthold had a great example in a publication recently. Since 1979, the average price of a new car has risen from $6,847 to $27,940, or 308%. But the CPI-adjusted series from the same date reveals only a 71% increase. Therefore, about $16,000 of the $21,000 increase is due to quality improvements and not in price inflation. Ironically, the repair bills aren't deflating. The BLS is now attempting to expand the number of CPI categories adjusted for quality improvement.

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?

Troubling Consequences

If 1% fed funds rates and 5% mortgages are "normal" in an environment of 6% nominal GDP growth, exploding commodity prices, strong real estate conditions and soaring equity markets, then things will be fine. If 1.6 million personal bankruptcies and up-to-the-edge consumption are sustainable, then I should call my banker to borrow a few million! If the concept of job/income growth supporting real, unlevered economic growth is obsolete in a finance-based economy, the day of reckoning need never appear. If there is no practical limit to the total debt-to-GDP ratio (yes, I know it compares a stock to a flow, but so does a price-to-earnings ratio!), then my concerns are for naught.

But if things are not very, very different this time, an adjustment to more normal savings, consumption and balance-sheet ratios could prove awfully painful. If the financial markets ever adjusted nominal interest rates for the current 3% to 4% true inflation rate, then watch out below.

Right now, investors are enamored with depressed interest rates and the Fed's ability to remain accommodative (I'd suggest promiscuous) for quite some time. Based on these factors, some market commentators contend that valuations should be significantly higher, overestimating the ability of today's conditions to endure.

My sense is that most investors perceive normal rates to be 100 or 200 basis points higher, so when Greenspan loses his "Easy" adjective, short rates will rise to 3%. But Greenspan himself recently noted the fact that the fed funds rate has historically matched the nominal growth rates of the economy. That relationship suggests short rates closer to 4% or 5% and bond rates around 6%. Both the economy and the stock market would have extreme difficulty adjusting to those levels.

If Easy Al ever summoned the courage to re-establish the historical relationship between the fed funds rate and nominal GDP growth rate, then all bets are off. His current 1% Wonder would rapidly develop into the 5% Fiasco!

Robert Marcin is the founder and general partner of Defiance Asset Management. Formerly, Marcin was a partner at Miller, Anderson & Sherrerd and a managing director at Morgan Stanley, where he managed the MAS Value fund (currently Morgan Stanley Institutional Value). At the time of publication, Marcin had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Marcin appreciates your feedback and invites you to send it to