Deflation Warning Hints at Policy Shift

The Guys at the Fed mostly think with one brain. Lots of group think. They just promoted Janet Yellen

In her time as a Fed policy maker, Ms. Yellen has never cast a dissenting vote on policy. Most of the guys are like her.

and ANOTHER source calls it.

http://www.ritholtz.com/blog/2010/07/inflation-versus-deflation/

From the comments section.

The government reports that CPI inflation has averaged around 2 percent so far this year. I’m not sure why Ritholtz calls deflation a fact. It’s not in the official data. The unofficial inflation rate reported by John Williams over at Shadow Government Statistics has the true inflation rate averaging around 5% year to date.

Source:
http://www.shadowstats.com/

Ritholz is very wrong here. The CPI under-counts inflation in many ways. And the real estate is due to over-supply, which an intelligent person would take into consideration.

Its not just teh Fed, Riversider. Its every major poll of ecnomists, and the spread between the 10 year benchmark and the ten year TIP. Basically, most people who know anything about the topic think you are widely wrong, and are putting there money where there mouth is.

right. from the comments. shadowstats.

I thought you respected ritholtz's opinion?

you are a raging idiot. there is over supply of everything. that's why prices are coming down. moron.

I do respect Ritholz, he's a regular read. I don't necessarily agree with him. There are many people I respect but don't agree with. Sometimes they make very good points and if persuasive enough, my opinion will adjust. But I understand your error.

droll.

A.R.
I've posted before that declining prices does not necessarily indicate a deflation problem. A couple of examples:
Technology lowers the cost of computers.. Deflation ? No!
We import more from china Deflation : no!

And back to the point, The consumer price index is flawed. It became really useless back during the Clinton Administration.

Shortly after Clinton took control of the White House, however, attitudes changed. The BLS initially did not institute a new CPI measurement using a variable-basket of goods that allowed substitution of hamburger for steak, but rather tried to approximate the effect by changing the weighting of goods in the CPI fixed basket. Over a period of several years, straight arithmetic weighting of the CPI components was shifted to a geometric weighting. The Boskin/Greenspan benefit of a geometric weighting was that it automatically gave a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price.

Once the system had been shifted fully to geometric weighting, the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third.

The BLS publishes estimates of the effects of major methodological changes over time on the reported inflation rate (see the "Reporting Focus" section of the October 2005 Shadow Government Statistics newsletter -- available to the public in the Archives of www.shadowstats.com). Changes estimated by the BLS show roughly a 4% understatement in current annual CPI inflation versus what would have been reported using the original methodology. Adding the roughly 3% lost to geometric weighting -- most of which not included in the BLS estimates -- takes the current total CPI understatement to roughly 7%.

http://www.shadowstats.com/article/consumer_price_index

When gasoline rises 10 cents per gallon because of a federally mandated gasoline additive, the increased gasoline cost does not contribute to inflation. Instead, the 10 cents is eliminated from the CPI because of the offsetting hedonic thrills the consumer gets from breathing cleaner air. The same principle applies to federally mandated safety features in automobiles. I have not attempted to quantify the effects of questionable quality adjustments to the CPI, but they are substantial

http://www.shadowstats.com/article/consumer_price_index

http://seekingalpha.com/article/216002-safeway-q2-2010-earnings-call-transcript

had second quarter expectation of .5 percent inflation, but wound up with 2.4 percent deflation. miss.

i recall speaking on a conference with John Williams. Man, was that an experience. That was the best panel ever, John Williams, Yves from NC, Bill from CR...I was lucky enough to convince the conference holders to get this crew together on stage. John was complete hyperinflationist back then, scrounging when I even mentioned deflationary threats.

Deflation is an argument used by advocates of increased government. I don't believe deflation is really the worry, just the excuse.

Urban,
What's your take on CPI? Do you think it's an accurate representation of inflation?

http://www.urbandigs.com/2008/07/inman_bull_vs_bear_debate.html

John Williams - Definitely the most bearish on the panel, discussed the concept of dollar destruction and hyper inflation. His serious tone clearly was interpreted by me that he is a true believer in government bent statistics on inflation and unemployment, and that the worst is yet to come. If the US dollar really does go to 'zero', and hyper inflation sets in, we may be in store for Zimbabwe style currency notes.

I disagree with the total dollar destruction and hyper inflation, mainly because I do not see wage inflation and rather, we are experiencing the side effects of commodity inflation (food & energy inflation) that arises when a central banks' primary focus is on reviving economic growth at the mercy of the local currency. The best medicine for high commodity prices IS high commodity prices that cause demand destruction and eventually a speculative trading reversal. In my humble opinion and as I stated many months ago, our dollar will get a boost as foreign CB's are forced to eventually lower rates to combat their own slowdowns right at the time our CB will shift their rate actions towards inflation fighting.

insanity.

is anyone here involved in a business outside of nyc?

what happens when sales in businesses go down?

This don't worry we don't have inflation, and point to the low treasury yields... misses the point.

We don't have deflatio, and we don't have hyper-inflation at the moment, We have mid-level single digit inflation. The problem with saying don't worry we can deal with it later reminds me of the cartoon character running with a ticking time bomb.. It hasnt' gone off, but we all know it will

" What's your take on CPI? Do you think it's an accurate representation of inflation? "

nope, its got its flaws but I think the changed methodology reflect a need to surpress inflation so as not to cause early problems with our underfunded entitlement programs. Sure the trend may be somewhat accurate, yet diluted.

Urban, does seem kind of circular...

we have insane credit destruction and destruction of assets derived from credit. everything else is a symptom of that.

study all the numbers you want. sales are going down. when sales go down, businesses have to cut prices. perhaps some will try to raise prices but once they see that their competitors are cutting, they are forced to follow.

urban, check out Chris Whalen's current piece on institutional risk analytics...

more academics? more statistics? find a small business owner who's sales are going up. impossible.

which article

the current one, he no longer leaves the archives available.
very widely quoted guy who is a regular advisor to congress on issues of banking and finance.

http://us1.institutionalriskanalytics.com/www/index.asp

"The Guys at the Fed mostly think with one brain. Lots of group think."

Funny, the article is mostly about how divided the Fed is over this issue. I guess there are some different thoughts going through that one brain.

a friend of mine has a bankruptcy firm, his business is growing

that's a joke i presume.

The only Fed guy who seems of a different mind at the moment is Thomas Hoenig. I think he's right, The Fed needs to raise the Fed Funds to around 1%

i dont think the banks are recapitalized nearly enough yet to warrant that kind of move, given other macro factors out there. I think we are at zirp until there is clear evidence this economy is turning around

Maybe not, but the transfer of wealth to the banking system via zero interest rate policy is in my opinion contributing to weak economic growth. People see they can't earn interest on their savings, feel poorer and spend less. Also at zero interest rate, people don't feel their money has value and economic decion making gets distorted.

I think you will see the Fed maintain a policy of zero real interest rates, which will only make inflation worse over time. People expect a positive interest rate when they save and invest. This is really setting us up for a new and bigger problem.

Metrics and outcomes from past economic cycles are less clearly applicable to our current situation
because of changes in technology and the US and world economies since the 1930's depression and even
the late 1980's meltdown. The internet accelerates and magnifies all trends, and tends to exaggerate
them in the very short-term. It also produces much more synchronized behavior by economic actors, as
in August 2007, when traders around the world pursued the same trading strategies, invested in the
same "safe" assets and sold tham at roughly the same time, causing, e.g., yields on AAA bonds to rise
above those on junk bonds.

Also, the US labor market is now internationalized, with the result that pricing power for most American wage earners, including young law firm associates who until recently could expect starting
salaries of $165,000, to disintegrate. One effect of that disintegration is that rising inflation will
not necessaily lead to higher wages. Rising inflation could just as easliy lead to collapsing rent,
which in economic terms is what is left over after all monthly necessities are paid for, which in turn
would cause substantial consequential erosion in residential RE equity values.

Inadvertently, RS, you gave the reason why they changed the calculation of inflation: "Technology lowers the cost of computers.. Deflation ? No!"

Because technology does not stay static. Therefore, if you bought a car today and compared it with one you bought in 1970, while they are both cars, the quality and technology are not comparable. Just adjusting for inflation without adjusting for the change in make-up.

Deflation only occurs when there is a decrease in aggregate demand; it does not occur when prices fall due to competition or economies of scale.

FYI.

"Just adjusting for inflation without adjusting for the change in make-up" = "Just adjusting for inflation without adjusting for the change in make-up is not sufficient to make a calculation of inflation."

Oops.

Ok, let's state this another way,

deflation = lower prices
but is anything that lowers prices something that is bad?
Case in point mass production 19th century.
huge discoveries of elephant oil fields in the one hundred years ago

Prices are going down now because aggregate demand has fallen.

Rb345. A coherent understanding of where we r headed.

Ever wonder why they use to wheelbarrow dm to breadmakers and doctors, and not borkers? Inflation is only relevant to actual 'necessities' of life. Who cares if iPods cost $1k? Or 7bdrm cpw is asking $20k/month. Pricing powered goods/services will inflate. Bernie got nothing left,3 yrs of zero and we are still deflating. Sorry it's just a good ole shake out. Say bye bye to your $200k salaries borkers. Those days are gone forever.

In conclusion, the laws of cash flow is trying to find a new equilibrium wo 20x leverage. Each good/service's ability to hold onto bubble pricing will be determined by capacity and marginal cost of producers. The fed or anyone's ability to limit this new equilibrium post the greatest synchronized re bubble known to man is just folly. Look at japan, boj is just a reactionary bunch of nimrods in ill fitting suits.

Economic forecasting has been inherently imperfect for decades because so many events of different
degrees of probability or foreseeability can occur which change the direction of current trends or
conditions.

Today doing so is much more difficult because of partial world economic integrattion, and the increas-
ingly complex structure of our socieites and economies, which makes them infinitely more vulnerable
to destabilixation and even collapse than even two decades ago. Case in point: the re-seiaing up of
the commercial paper markets worldwide after Greek bonds were revealed as a latter day Trojan Horse:
solid appearing on the outside but hollow on the insure.

That complexity - and interdependency - makes a major, system-disrupting event far more likely that it
has been in any previous economic cycle, which makes planning far more difficult, and dramatically reduces the reliabilitu of all economic forecasts.

If we cannot agree on the inflation rate, how can we agree on whether there is inflation or deflation?
No one can deny that the CPI under-counts inflation, the question that is open is by how much.

I don't know about you guys but when beef goes up and I switch to Turkey, I don't consider that inflation neutral. When Salmon goes up and I switch to arctic char, prices have still gone up. When the government makes us add ethanol to gasoline and says prices did not go up because the air is cleaner, I don't consider that inflation neutral. When home prices shot up earlier a few years ago, I didn't say that wasn't inflation.

My point is deflationists don't count things that go up. And relable cost savings as an economic disaster.

Idiot.

What happens to the price of beef when everyone switches to turkey?

Let 'me get this. When beef is $.10 more you buy chkn, but when owning costs 3x more than renting you sit on your coop cause you are too embarrassed to have the movers move your 800lb body?

and to echo my esteemed colleague from w67th st.

absent any increase in wages, what happens when the price of essentials like food goes up? yes, among other things real estate prices go down.

and what markets are most exposed to this type of problem? certainly those that were most out of whack to start with?

to simplify, we have been living beyond our means for quite a while fueled by an explosion of debt. the ability (and desire) to borrow has evaporated despite the fed's valiant effor to lower interest rates to zero. less ability to spend = less spending. less spending will lead to unprecedented price drops in discretionary items.

I must be living in China , Russia or Iran
The government insists prices are declining yet everything I buy or service I use costs more..

hmmm

What happens, cc, is what you see in safeway's second quarter report. the cost of food decreases. Safeway, with its other brand stores, is one of the bigger non-discount grocery chains.

no...the things that you choose to buy and where you buy them. but, as an established idiot, its not surprising that you would overpay for everything.

t

sorry, error. but rs what about that grocery store report?

I don't know what Safeway's product mix is and what's driving their margins. Perhaps their customers eat tv diners or the owners drive too many porsche's but agricultural commodities are soaring. Cost of food is going up. How can you not live in NY and feed your family Fish, fresh fruits,vegetables and not see this?

http://www.spiegel.de/international/business/0,1518,708765,00.html

They are now betting big again on commodities like wheat, coffee, rice and soybeans. As a result, prices are no longer determined by supply and demand, but by investment banks and hedge funds.

Cocoa isn't the only commodity that has become significantly more expensive in recent months. The price of wheat has gone up by 17 percent since April, and soybeans by 12 percent. At the beginning of the year, sugar prices climbed to their highest level in three decades in the space of only a few months and then plunged by almost half. But now sugar prices are back up, climbing by almost 6 percent since April.

The food price index of the United Nations Food and Agriculture Organization (FAO), which aggregates price movements for key agriculture products, climbed to 163 points in June. This is only 15 percent lower than the all-time high of 191 points in 2008, the year of the financial crisis.

Price Explosion

At the time, rice prices rose by 277 percent within only six months, and corn became so unaffordable that millions of Mexicans could no longer afford tortillas, a staple in the country. Hunger riots erupted in Haiti, Egypt and more than 30 other countries.

Driving the price explosion was the growing use of agricultural commodities to produce biofuel. But 2008 was also the year in which, for the first time, the public realized that grain merchants were no longer the only ones trading on the exchanges (in their case, by buying grain futures to hedge against poor harvests), but that the major players in the financial markets had discovered the lucrative trade in agricultural commodities.

Last year, Goldman Sachs earned $5 billion in profits with commodities alone. Other major players include the Bank of America, Citigroup, Deutsche Bank, Morgan Stanley and J.P. Morgan.

It is volatile, but the Rogers Agricultural Commodity Index has a one year return of 8%, which in my mind is closer to the true increase in prices we are seeing for food at the retail level. The government indices are just an outright lie. The information is out there. If you look around you can track the prices of corn, wheat, soy, orange juice, hogs(by the way hog future are up 47% this past year according to a bloomberg news story), etc.

ar is trying to defend Obama's irresponsible spending policies and deficit explosion by saying it won't affect inflation. That's my guess on what is behind her deflation argument.

once again, licc doesn't have a clue. I want deflation?

actually the safeway report found the biggest deflation in dairy and produce and expects it to continue. nice use of 2008 data rs.

Fiscal and monetary policy will not fix our current problems because they are very different from past problems. The consumer is over-leveraged and cannot and should not be encouraged to borrow for things he/she does not need. Monetary easing will not increase consumer borrowing and will only hurt savers. Fiscal stimulus will fail because we are already too indebted as a nation.

This time really is different.

and that is germane to this discussion how?

http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100007034/drip-after-drip-of-deflation-data/

Was a response to LICC.
Again, I understand how you like data. Instead of focusing on an individual company that may have some unique problems, perhaps you could track some key agricultural commodity prices. For the most part they are all rising.

you do understand the concept of not being able to pass along cost increases to consumers in terms of final prices, no?

never mind, maybe you don't, or maybe you just prefer to ignore that aspect as it isn't consistent with your world view.

That is just one of those pesky details that he/she chooses to ignore.

Soon we will hear for the hundredth time how prices at citarella are going up.

What kind of food do you buy? Visit Fairway, Visit Citarella. They have a fantastic selection of healthy food, which all costs more. Maybe they are not passing the entire cost through but prices are going up. Do you only shop at the frozen food aisle?

reflecting, of course, the pulse of the nation much better than safeway or piggly wiggly.

So data from safe way is not relevant because they only have what 1,000 stores?

But citarella is a international barometer?

And don't forget, the price of shrimp has gone up.

hi-larious. I shop at whole foods, trader joes, and the local fruit vendor. and no I haven't seen prices go up.

Whole Foods is a very expensive store. They have traditionally over charged by a huge amount, so if they are over-charging less, you are being fooled.

Is the sky blue?

clearly you don't shop there. citarellas a bargain. hahaha.

I guess the word hilarious truly lacks meaning until you hyphenate it, or maybe throw a curse in mid-word.

Dairy prices up! It's good to be a cow.

http://future.aae.wisc.edu/data/weekly_values/by_area/1617?tab=prices

ar, you need to read more carefully. I didn't say you wanted deflation. But you probably are downplaying inflation because you want to focus away from the negative consequences of what Obama is doing.

downplaying what inflation?

I would love a bit of inflation.

you really don't get it. I'm not that fond of Obama.

Very few people are these days....

No one in their right mind would want deflation. Particularly if you own any assets.

http://future.aae.wisc.edu/data/monthly_values/by_area/303?tab=prices

What a surprise. selective posting.

You have to be kidding, You feed your family cheddar cheese?

How about some healthy yogurt?

Do you consume a lot of powdered milk?

This?

http://en.wikipedia.org/wiki/File:Easy_cheese2.jpg

more to the point, just think of the sad cows whose bodily fluids are being turned into cheese. guess it's not so good to be some cows

and those weren't even retail sales rs listed. shoddy, shoddy, shoddy.

Point is if you factor out declining rents resulting from an over-supply of housing prices are up. The cost of the door-man in your building costs more, the cost of the engineer maintaining your building costs more, the cost of sending your child to college costs more, the cost of filling up your car at the pump costs more, the cost of a trip to the barber costs more, the cost of cooling your apartment costs more, the cost of talking on your cell which is now an i-phone costs more, the cost of time warner cable costs more, the price of using the subway costs more, the price of purchasing insurance costs more, taxes cost more, everyone's except your grocery bill has gone up

but in every case, the consumer has a choice. a choice to pay more or shift consumption. and virtually everyone is shifting consumption. which means that price increases won't work. then those businesses that attempted to increase prices will either back off or go out of business.

not a good time to be saddled with long term fixed obligations.

@RS: Because I know you like the youtube (and ducking and weaving):

http://www.youtube.com/watch?v=OIwZRU9f-TM

demand elasticity. such a basic economic concept.

RS, what's your point about American pasteurized processed cheese food spread?

Do you prefer the original American pasteurized processed cheese food spread to the spray-on American pasteurized processed cheese food spread?

rs, you feed your family powdered milk?

When you hear about inflation on TV, don’t you often wonder why the official number seems lower than inflation feels to you when you go shopping? It’s an open secret in Washington, but the Consumer Price Index (CPI), the common measure of inflation, understates inflation. How this occurred is not entirely clear, although many speculate. However, what is clear is that it means you are being deceived about the state of the economy.

Substitution effect
The changes in inflation measurement began in earnest during the Carter administration as inflation began to spiral out of control. In the 1990s, a (potentially false) debate began about whether the CPI actually overstated inflation. The argument was as follows: if the price of beef increases, people will switch to buying chicken in what is known as the substitution effect. In essence, the relative weighting of the basket of goods changes as the price level for individual basket items increases.

The Boskin Commission was formed in order to investigate these issues. Wikipedia describes the conclusions resulting from the Boskin Commission

The claims of the Boskin commission were dubious.* However, it was decided to re-weight the basket of goods as prices rose on individual goods in order to reflect the substitution effect. As a result, the CPI does not measure true inflation through a static basket of goods, but an ever-changing basket based on consumers substituting out basket items as they rise in price. As an example, it’s like re-weighting the index to reflect the fact that more people are buying beer because wine has become too expensive. This serves to understate the true cost of the desired basket of goods in favor of a less expensive actual basket.

Hedonics
The next major step taken in the 1990s was around the issue of Hedonics. As technology advances, items like Computers and Televisions become more sophisticated. This increase in sophistication that consumers enjoy is not taken into effect by the actual price of the goods. Therefore, the CPI must be adjusted downward to capture the hidden price reduction from ‘hedonic improvement’ or so the theory goes. As an example, a Computer in the year 2008 is much more sophisticated than one from the year 2002. Therefore the theoretical price of the computer in 2008 must be adjusted upward to reflect this. Since the actual price is less than this theoretical price, the difference serves to reduce the measurement of inflation.

If this sounds like nonsense to you, I can’t argue with you.**

Core Inflation
The last ridiculous inflation calculation is the Core CPI. This measures the rate of inflation minus food and energy. Food and energy are two of the largest components in the basket of goods we buy. But they are excluded in order to see the underlying ‘core’ inflationary trend. The theory goes like this: Because food and energy prices are volatile in ways that have nothing to do with the overall state of the economy and the inflationary pressures resulting from the business cycle, to predict the future path of inflation, they must be excluded.

The problem with the Core CPI is that it has been woefully inadequate in signaling the danger associated with stubbornly high food and energy price inflation. If the cost of milk, rice, OJ, oil, or you name it keeps rising for months or years, the Core CPI becomes meaningless. That is what has happened over the past few years.

Conclusion
All of which is to say: We have a very distorted view of inflation. As a result, we have a very distorted view of the real growth rate of the economy. If the CPI were measured today as it was in the 1970s, we would have seen a much deeper recession in 2001-2002 and we would see that we were clearly in recession today. Like it or not, the present meausure of inflation has deceived the general public into believing the economy has been more robust over the past 15-odd years than it actually was.

*The website Shadow Government Statistics does an excellent job of re-working Government statistics to reflect the CPI before the Boskin commission and before other changes in the index.

**Hedonic adjustments only serve to lower inflation by artificially lowering the cost of goods. But, what about service? Why us there not an increase in the implicit cost of services using Hedonics. After all, service quality has declined as most things have become automated. Calling customer service in today’s world is significantly ‘more expensive’ from a hedonic perspective than it was in the 1980s. This example demonstrates how these adjustments cumulatively skew CPI downward.

Read more: http://www.creditwritedowns.com/2008/04/cpi-understates-inflation.html#ixzz0vBHkiycy

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+June+2008.htm

You can fool some of the people all of the time,
and all of the people some of the time,
but you cannot fool all of the people all of the time.
– Abraham Lincoln

The U.S. seems to differ from the rest of the world in how it computes its inflation rate in three primary ways: 1) hedonic quality adjustments, 2) calculations of housing costs via owners’ equivalent rent, and 3) geometric weighting/product substitution. The changes in all three areas have favored lower U.S. inflation and have taken place over the past 25 years, the first occurring in 1983 with the BLS decision to modify the cost of housing. It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of the substituted owners’ equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.

In the 1990s the U.S. CPI was subjected to three additional changes that have not been adopted to the same degree (or at all) by other countries, each of which resulted in downward adjustments to our annual inflation rate. Product substitution and geometric weighting both presumed that more expensive goods and services would be used less and substituted with their less costly alternatives: more hamburger/less filet mignon when beef prices were rising, for example. In turn, hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durables. As your new model MAC or PC was going up in price by a hundred bucks or so, it was actually going down according to CPI calculations because it was twice as powerful. Hmmmmm? Bet your wallet didn’t really feel as good as the BLS did.

In 2004, I claimed that these revised methodologies were understating CPI by perhaps 1% annually and therefore overstating real GDP growth by close to the same amount. Others have actually tracked the CPI that “would have been” based on the good old fashioned way of calculation. The results are not pretty, but are undisclosed here because I cannot verify them. Still, the differences in my 10-year history of global CPI charts are startling, aren’t they? This in spite of a decade of financed-based, securitized, reflationary policies in the U.S. led by the public and private sector and a declining dollar. Hmmmmm?

In addition, Fed policy has for years focused on “core” as opposed to “headline” inflation, a concept actually initiated during the Nixon Administration to offset the sudden impact of OPEC and $12 a barrel oil prices! For a few decades the logic of inflation’s mean reversion drew a fairly tight fit between the two measures, but now in a chart shared frequently with PIMCO’s Investment Committee by Mohamed El-Erian, the divergence is beginning to raise questions as to whether “headline” will ever drop below “core” for a sufficiently long period of time to rebalance the two. Global commodity depletion and a tightening of excess labor as argued in El-Erian’s recent Secular Outlook summary suggest otherwise.

The correct measure of inflation matters in a number of areas, not the least of which are social security payments and wage bargaining adjustments. There is no doubt that an artificially low number favors government and corporations as opposed to ordinary citizens. But the number is also critical in any estimation of bond yields, stock prices, and commercial real estate cap rates. If core inflation were really 3% instead of 2%, then nominal bond yields might logically be 1% higher than they are today, because bond investors would require more compensation. And although the Gordon model for the valuation of stocks and real estate would stress “real” as opposed to nominal inflation additive yields, today’s acceptance of an artificially low CPI in the calculation of nominal bond yields in effect means that real yields – including TIPS – are 1% lower than believed. If real yields move higher to compensate, with a constant equity risk premium, then U.S. P/E ratios would move lower. A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate.

A skeptic would wonder whether the U.S. asset-based economy can afford an appropriate repricing or the BLS was ever willing to entertain serious argument on the validity of CPI changes that differed from the rest of the world during the heyday of market-based capitalism beginning in the early 1980s. It perhaps was better to be “entertained” with the notion of artificially low inflation than to be seriously “informed.” But just as many in the global economy are refusing to mimic the American-style fixation with superficialities in favor of hard work and legitimate disclosure, investors might suddenly awake to the notion that U.S. inflation should be and in fact is closer to worldwide levels than previously thought. Foreign holders of trillions of dollars of U.S. assets are increasingly becoming price makers not price takers and in this case the price may not be right. Hmmmmm?

What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.

Investment success depends on an ability to anticipate the herd, ride with it for a substantial period of time, and then begin to reorient portfolios for a changing world. Today’s world, including its inflation rate, is changing. Being fooled some of the time is no sin, but being fooled all of the time is intolerable. Join me in lobbying for change in U.S. leadership, the attitude of its citizenry, and (to the point of this Outlook) the market’s assumption of low relative U.S. inflation in comparison to our global competitors.

William H. Gross
Managing Director