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This week Wall Street finally began to acknowledge
the possibility that all is not necessarily sanguine on the
inflation front after all. This rather reluctant and long
over do admission of the obvious came as a result of a .3%
increase in April’s core CPI, .1% greater than what
had been expected. Though traders routinely ignore far more
significant negative surprises with respect to headline inflation
numbers, they are not as forgiving when it comes to the sacrosanct
“core.”
The interesting aspect of April’s .3%
rise in core CPI was that it was in large part the result
rents, which are finally rising now that housing prices, which
are excluded from the CPI entirely, are beginning to fall.
Though this apparent irony may come as a surprise to Wall
Street, it is precisely what I predicted would happen. Though
I have written repeatedly on the folly of Wall Street’s
cult like fixation on “core” numbers, my March
2004 commentary reproduced below hits this week’s nail
right on its head. It was so dead on accurate in its forecast
that I have little else to write on the subject other than
“I told you so!”
Wednesday, March 17, 2004
Pro-forma Inflation Revisited
With the release of February's CPI, Wall Street
once again rejoices under the delusion that there is no inflation.
For the month of February the CPI rose by.5%. However, seasonally
adjusted, it only rose by.3%, and excluding food and energy,
it rose by only.2% It is the.2% figure, the "core"
CPI, which Wall Street and the Fed are celebrating despite
the fact that.2% was twice what had been forecast. However,
the actual, unadjusted CPI, which is what consumers really
paid, increased.5%, for an annualized inflation rate of over
6%.
If we look at what actually happened to prices
in February, as apposed to what government reports pretend
happened, we see the following price increases: soybeans 13.2%,
corn 7.75%, copper 19%, silver 7%, lumber 11.3%, crude oil
12%, unleaded gasoline 11%, heating oil 9.5%, and natural
gas 8.5%. Those percentages are not annualized; they are the
actual percentage gains during the month of February alone!
All of these prices have increased significantly thus far
in March as well.
Perhaps the most bizarre of Wall Street’s
CPI rituals is the routine exclusion of food and energy prices
from the CPI because these components are considered volatile.
However, over the past several years, all of the volatility
has been in one direction, up. Therefore excluding food and
energy on that basis makes no sense. It is similar to a CEO
excluding regularly occurring expenses when reporting earnings
by labeling them as extraordinary. To me "core"
CPI is the Fed's own version of pro-forma inflation!
The "core" CPI is actually of little
value since about 40% of it is comprised of rent (either actual
or owner-equivalent). In the current low interest rate environment,
which has drawn in an ever-widening pool of home buyers, rents
are being artificially suppressed. What’s more, the
proliferation of adjustable rate mortgages and no down payment
loans have temporally turned many renters into buyers; fully
one third of first-time homebuyers are putting zero down!
As a result, the national rental vacancy rate is at a 40 year
high, and rents are under pressure. Therefore, the Fed's inflationary
monetary policy is paradoxically helping contain rent increases
which represent 40% of the "core" CPI, while causing
housing prices themselves, which are not even included in
the CPI, to soar. The more inflation the Fed creates, the
lower the "core" CPI. How convenient.
As an example, if a tenant who rents a two-bedroom
apartment for $900 per month discovers he can purchase a two
bedroom condo with a zero down one year ARM for only $800
per month, his landlord is forced to either lower the rent
or lose the tenant. Under a normal interest rate and credit
environment (which requires down payments), the barriers to
purchasing condos would be much higher, giving landlords the
flexibility to raise rents.
In fact, one of the main factors restraining
increases in the CPI is the low interest rate environment.
Interest rates represent the cost of capital. Businesses are
able to pass on their lower cost of capital to consumers in
the form of lower prices. One of the reasons that the landlord
in the above example is able to reduce the rent is that his
interest costs are lower. Most landlords have mortgages, and
are able to pass on their lower interest payments to their
tenants in the form of lower rents. So, for example, even
as General Motors faces higher steel costs, higher energy
costs, higher workman's comp. fees, and higher health insurance
premiums, its cost of capital it significantly lower. Lower
capital costs help offset higher raw material and labor costs,
restraining the over all increase in consumer prices. The
same is true for businesses in general, particularly those
with significant amounts of debt to service.
The irony of the situation is extraordinary.
The Fed points to an absence of inflation as indicated by
a benign "core" CPI as justification for its low
interest rate policy. But it is that very low interest rate
policy that is temporarily suppressing the "core"
CPI. The prices that are increasing, such as commodities and
housing, are either excluded from the "core" CPI
or from the index entirely.
The problem for the Fed is that once general
price increases become so powerful that they overwhelm the
restraining pressure currently being exerted by rents, the
Fed will be forced to raise interest rates. That will have
the immediate effect of driving up the cost of capital, and
increasing the cost of buying a home. This will provide landlords
with the impetus and the ability to raise rents. Since rents
represent 40% of the "core" CPI, each time the Fed
raises interest rates to fight inflation, the "core"
CPI will rises faster, necessitating further rate increases.
Thus, the virtuous cycle becomes a vicious one. Housing prices,
on the other hand, will be falling, but those price declines
will not offset rising rents, as housing prices are not part
of the CPI. An economy that lives by "core" CPI,
will die by it, as well.
Now that reality is beginning to set in, time
is running out to get out of the dollar. Protect your wealth
and preserve you purchasing power before it’s too late.
Download my free research report on the powerful case for
investing in foreign equities available at
www.researchreportone.com
, and subscribe to my free, on-line investment newsletter
at http://www.europac.net/newsletter/newsletter.asp.
Peter D. Schiff, President
Euro Pacific Capital, Inc.
10 Corbin Drive, Suite B
Darien, Ct. 06820
phone 203-662-9700
toll free 888-377-3722
email schiff@europac.net
web www.europac.net
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