Some Unconventional Wisdom on Inflation

It has been overshadowed by the market's wild gyrations, which had mercifully subsided early Friday, but the inflation debate is back.

On Wednesday, the Labor Department reported the consumer price index rose 0.2% in January, putting its year-over-year increase at 1.1%, the lowest since 1986. Many believe even that modest level overstates inflation, The Wall Street Journal reported Thursday, detailing the government's plans to revise the CPI.

Beginning this summer, the government will use the chained CPI, which is adjusted for spending on certain goods as prices rise and fall. Predictably, the plan has raised the hackles of those who don't adhere to the conventional wisdom, as chanted mantra-style by most Wall Street economists and certain Federal Reserve officials:

Inflation is contained.

Inflation is contained.

Inflation is contained.

Repeat ad infinitum

"I don't understand some of these arguments" for the planned changes, said Paul Kasriel, chief U.S. economist at Northern Trust. "If the price of one thing goes up, there's a reason I'm buying less of it: It's called inflation."

Those who buck the conventional wisdom refute the argument that CPI overstates inflation, arguing that falling energy prices have masked rising prices in other sectors of the economy in the past year. Furthermore, they suspect the drive to restate the index is being driven by political considerations.

Kasriel, who has long warned about inflation's potential re-emergence, candidly admitted pricing pressures have proved weaker than he anticipated.

"There's no getting around it, energy fell and the overall inflation rate fell," he said. "To me the question is if energy prices stabilize -- not even rise -- and service sector prices continue to move up at the same pace, what's that going to do to the inflation rate?"

James Bianco, president of Bianco Research in Barrington, Ill., expressed a similar view, noting that energy comprises just 6.5% of the CPI. "The other 93.5% of the index's components is in an uptrend," he said. "If gas prices just stabilize here, you'll see a big uptick in the CPI."

The core CPI, which excludes food and energy, rose 2.6% in a year-over-year basis through January, after also climbing 0.2% last month.

Furthermore, the Cleveland Fed reported Wednesday that its Median CPI, which doesn't automatically exclude any particular sector, rose 0.3% in January, bringing its year-over-year increase to 3.9%.

I know, I know: Inflation is contained.

The New Third Rail

Kasriel and Bianco agreed on one other critique about the planned changes to the CPI: There's a political element.

The current administration would certainly benefit from a lower CPI, because Social Security payments and other government outlays are linked to the index. Lowering them would help mitigate the budget impact of the White House's efforts to lower taxes and simultaneously increase spending.

Michael Boskin, who headed a commission that concluded CPI overstated inflation by 1.1% annually, was formerly chairman of the Council of Economic Advisers in the first Bush administration. He is also believed to be on the short list of possible replacements for Fed Chairman Alan Greenspan, whose current term expires in June 2004.

"He's relatively apolitical even though he worked for Papa Bush, but I have wondered about this," Kasriel said.

Boskin did not return a phone call seeking comment.

Calling it "the one conspiracy theory I believe in," Bianco took it a step further, saying the entire federal government has an incentive to lower CPI. Government payments to some 80 million Americans -- Social Security and food stamp recipients, plus military and federal Civil Service retirees and survivors -- as well as the federal tax structure are pegged to the index, according to the Bureau of Labor Statistics.

Additionally, he suggested if the real inflation rate is close to the year-over-year gains of 2.6% or 3.9% for core CPI and the median CPI, respectively, "then the fed funds rate is too low and the Fed has a lot to do on the upside."

"This index is what the money is riding on," the market watcher continued, noting there have already been nine changes to CPI since the Boskin commission's findings in 1996.

"People always argue government statistics are wrong, but do they go through the effort of making nine changes" to any other piece of data?, Bianco mused. "The reason they went through all this is because there's a lot of money riding on this index. There's not only a vested interest in getting it as low as possible, they were blessed by the Boskin commission to do so and they rushed in."

Because of all the changes, which include adjustments for generic drugs and the rising quality of computers, "not only is CPI not a bad measure of inflation, it's probably the best around," Bianco argued. The notion that CPI still overstates inflation is "urban legend put out by bulls that are desperate to get higher equity prices" and lower bond yields.

P.S.

I suspect the above is going to raise the ire of many readers, especially those who recall that I've been writing about the potential for the return of inflation for the better part of a year. Some might charge that I'm focusing on the core or median CPI because those figures support my viewpoint. Maybe so, but doesn't the same hold true for those economists who focus on the personal consumption expenditures or core CPI minus insurance?

As always, I welcome debate, although please note that I repeatedly wrote last year that inflation could be a problem when the economy rebounded, although clearly that process has been lengthier than originally contemplated.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to Aaron L. Task.

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