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Video transcript

everyone's talking about inflation and deflation these days including myself and that's because it's important and in order to really have an informed view on it I think it's important to actually look at how inflation is defined and right here I actually took a screenshot from my Bloomberg terminal of the basket of goods that makes up the consumer price index the index that sets everything from the coupons on Treasury inflation-protected securities this is the index that dictates what Social Security payments are going to how fast they're going to grow I'm sure a bunch of union agreements and pension agreements are depend on the CPI so this is this is the underlying basket of because it really tells us what inflation is and at a first level it's just fun to look at because you can you know you can kind of compare your own household to what the government thinks is a typical household for example the government says that the typical house bowl household spends fifteen point seven percent of their disposable income on you know and that's essentially the income that you take home after you paying taxes that they spend 15.7 on food and beverages that seems reasonable but it's even kind of more interesting that they break it down I mean they get very granular they try to figure out how much do you spend on you know eggs and fish and poultry and bakery products and and that's good because let's say everything else stays constant but the price of eggs goes through the roof because you know Atkins died the Atkins diet becomes popular again then you can actually make an informed decision as to why inflation is going up or why or you know whether inflation will go up going forward so that's just interesting to look at and if you look at the major categories that food and beverages housing and I'm going to come back to housing because this is in general just a very interesting area to focus on because it makes such a big portion of the CPI and it's been such a big portion of the economic picture especially the last ten years and and obviously it's become a big problem with the it's become a big factor in terms of what's causing the financial crisis right now but housing is about 43 percent of disposable income a parallel three percent transportation 15 percent this includes things like southern you new vehicles four percent used cars and trucks and I think the way they calculate say oh you know what percentage of Americans are driving you you new vehicles versus you've used vehicles and they put fuel in here and it's going to you know the point that a lot of people when I have this inflation deflation argument they they make this argument that China and India are going to continue growing and because of that commodities like oil and fuel will continue to increase although that's you know people were making that argument more last summer but even now people are making that argument but in in a developed country you see that really motor fuel even though it kind of hits your pocketbook on the margin it isn't that big a part of kind of your total expenditure especially when you when you compared to things like housing and if you keep going down medical care six percent and then recreation either they break it down and you could look this up I think the Bureau of Labor Statistics has this broken down as well though it was much easier to get it on the Bloomberg terminal education you know an average three percent obviously if you're sending your kids to college that's a much higher number but on average if you take the average household and finally other goods and services tobacco etc etc so that one is just interesting to look at so whenever you have a discussion on the things that might may or may not drive inflation it's important to wait them by these weightings that the CPI gives them to actually figure out what the actual impact on on how we measure inflation really will be and with that said if you think about it the really the biggest portion of this is the housing piece right housing and and I think that's fair housing is a large percentage of most people's disposable income especially in a Western society you can imagine if you live in a third world country and you're barely getting by food might be a huge part of your expenditure and you know maybe rivaling housing if you've kind of you know if you've just kind of built a house someplace but in a developed society housing is a huge percentage of it and I want to focus on one thing and this is a lot of people have talked about this and actually mich once again from global economic analysis he he really encouraged me to highlight this so within housing obviously some people rent some people buy and so they give a 6% weighting of the whole basket to rent and then they give a 20 roughly 24 25 and waiting to something that they call owners equivalent of rent of primary residence so this is essentially their attempt to measure how much it cost to live for people who own houses but what's interesting and you probably have caught on to it is that they use the word owners equivalent rent so what they do and this is the current methodology they don't say how much is your mortgage they don't say how much does it cost you to you know buy that house and amortize it over the life of you know the the reasonable life of the house they actually just say how much would it cost to rent that house and they've they've kept waffling back and forth between sometimes they they just look for equivalent houses and they say well how much would that cost to rent at one point they're actually surveying people and said they would ask them how much would it cost to rent your house which is probably even a worse number but the bottom line is they're not factoring in actual mortgages and you can even see it on the waiting right you know right when I looked at these numbers I was like well you know roughly 66 percent of people owned houses how come this number isn't 66 percent relative to this number right it's closer to 80 percent it's like oh we know that's fair because more people actually live in homes right you could say that 66 percent of of overall households own but in general homes are bigger there might be more people in it so you could either think of it on kind of a person basis or maybe on a square footage basis it makes a little bit more sense to wait houses higher but what's interesting here is that this number especially if you if you know if you add these two housing in general it's about 30 percent it's about 30 percent of disposable income and traditionally that was you know kind of the rule that a a bank would use to decide whether you can afford a house in Muniz shouldn't be more than a third of your disposable income or at least a mortgage payment shouldn't be more than third but we know especially over this last this last real estate bubble that that has become a much much larger percentage of people's actual disposable income so you know you wonder well why is this weighting only thirty thirty percent of the Spoils income well that's because they use owner owner the equivalent rent they didn't actually say what people's mortgage payments are so even though mortgage payments might be going through the roof even though the price of a house might be going through a roof it does not get reflected in the in the CPI number as of the early 80s and actually go to the this is straight from the Bureau of Labor Statistics website and they wrote and they actually using doublespeak here I just copied and pasted straight from their website until the early 1980s the CPI used what is called the asset price method to measure the change in the cost of owner-occupied housing that makes sense and I'm not sure what they did they just looked at how much houses cost this year relative to last year and they and then they put that into the weighting or they determine the weighting based on people's average mortgage but in general that's a good way to measure it right either with your mortgage payment or how much houses cost and they said the asset price method treats the purchase of an asset such as a house as it does the purchase of any consumer good fair enough because the asset price method can lead to inappropriate results and this this is the key line because the asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons I agree with that if something is per is purchased largely for investment reasons if I'm purchasing gold maybe that shouldn't be included in the CPI because it's largely for investment reasons or for stocks but then they use this kind of completely disjoint logic and they say you know because asset price method can lead to inappropriate results for goods that are purchased largely for investment reason the CPI implemented the rental equivalents approach to measuring the price change for owner occupied housing that's to me that makes no sense right owner occupied because I mean owner occupied is not purchased for investment raising that I would I would that's a fair enough argument if you're doing it for rentals if you're doing it for vacation homes but for actual owner occupied housing this sentence makes no sense based on their own rationale there's no reason to transfer to this this rental equivalent approach but the whole reason why I'm you know I'm going here is because because they've they've in ninth in the early 80s I think 1983 or say it right here in January 1983 because they switched over to this this kind of inflation that we've seen in the price of houses especially the the real estate bubble we've seen the last 10 years in no way got incorporated into the inflation numbers so it essentially understated them and you can see that here this is well two things not only did it understate it but it probably understated the weighting itself and mish he's made he's had a couple of posts about this that you know you really should use something like the case-shiller index on this line right here instead of doing this owner equivalent but I'd argue one step further not only should you use something like the case-shiller index but to actually gauge this weighting you should actually survey people and just say what percentage of your disposable income is dedicated to your mortgage and other things related to owning a house and especially over the last seven years I would guess and I'm almost sure about this that it would be much larger than 30 percent of your disposable income so not only was this number being understated or the growth in that number because it didn't incorporate the increase in housing prices but this weighting itself was understated and just to get a sense of how much this is the Case Shiller index and you could look up the Case Shiller index but in my opinion is the best index for actual increases or decreases in the price of homes you see from 2001 to 2006 roughly houses were increasing by 10 to 15% a year so if you use that instead of the rental equivalents and over the same timeframe I don't have a chart for rent but rent was not increasing it anywhere near this pace if anything people were leaving apartments to buy houses so rent was actually staying pretty stable but 10 to 15 percent this is year-over-year growth this is what this chart is so 10 to 15% if you wait that at 30 percent of people's of the of the CPI basket then really the the reported inflation number was being understated by three to five percent a year and I had argued that that weighting should have been this weighting should have grown over that time period because people were spending more and more of their disposable income on their mortgage payments so really it was probably understating it by more that this weighting should have been more like 40 percent and you could have said they were understating it by 4% four to six percent and if you look here you know this is the actual reported CPI numbers what I'm saying is over that time frame the real inflation numbers should have been up here and then now that we have actual deflation and home prices this is zero so now the most recent case Shiller numbers say that housing has depreciated by twenty percent we're essentially understating the the deflation now so although you know right now the CPI has a said kind of the zero mark if you actually incorporated the real prices of homes and you didn't use rents as a proxy for it you would actually get a much more negative number here and Mitch actually did that on his blog and if you actually want to read his blog which I highly recommend do a Google search for mish Mis H and this is directly from his blog so after give him credit for that and what he did here is he actually charted the actual inflation numbers that's reported that's in blue and then on top of that he he put what he calls the case-shiller CPI index and that's in red and you see here or especially over the housing book this is what we got this is the these are the inflation numbers we got from the government which put things you know they peaked out in the four or five percent range which isn't low by any stretch of the imagination and that's probably why the Fed started increasing interest rates right around here right but you know arguably at the worst possible time but if you look at the the CS CPI or the Case Shiller CPI you could almost say that the real inflation was actually peaked out let's see that number in the eight percent range back here and you could argue that if this was the actual number that the Fed was using it would have actually been a much better policy tool because they would have seen the inflation pop up back here in January of three and they would have known that they were keeping their monetary policy too loose back here and they could have avoided this whip song that they did in in in 2007 and 2008 and I'd argue even further that even this number is understating the reality because back here as a percentage of the actual CPI basket he just took that the CPI numbers and replaced the year-over-year change essentially into the same weighting as the current CPI numbers but if you actually weighted it based on the act amount of disposable income people were spending on their mortgages I would guess it would look something more like this and you would have seen actual inflation peak out here probably in the 10 or 11 percent range and you know there's a lot of I guess the social commentary about this why they do it one you know one argument is is that a lot of the governments or even corporate liabilities liabilities are indexed to inflation right you have an inflation index and on the other hand the the sale of homes it essentially transfers wealth from one generation to another especially when you have a huge increase in that in the the price of homes so by you know if you if they did this on purpose and I'm guessing that they did what it allows something it allows housing prices to increase dramatically and when housing prices increase dramatically it essentially allows it transfers wealth from the new buyer generation to the retiree generation so it helps subsidize the retirees and at the same time by taking it out of the actual CPI index it keeps the government and actually a lot of other corporate liabilities low because now Social Security it's indexed to inflate index to the CPI number so if you if the CPI numbers are not incorporating or you know are not raising up here you don't have to increase people's Social Security payments and you kind of get to you know project this farsh to people that you say Oh an inflation adjusted terms you are doing better than your parents generation did oh but by the way you can afford one-third the house now and you know to some degree that's been propagated to large it's you know obviously all falling apart now but the the big takeaway from this if I had to give you just one is that the CPI index is a government created tool it's based on a survey and not only has it not been the same survey but it's actively changed over the years as changed in ways that significantly impact the actual numbers that are reported and to some degree play into what I think government wants people to believe anyway see in the next video