Thursday, February 22, 2007

Inflation Off the CPI Radar

Balance. Ah, money supply balance. We've been looking for a quick fix for this ever since we drifted away from the gold standard.

Today, it's all "managed" by our central bankers, who take a few measurements and "presto!" -- that's how much money we need in circulation. Let me take you on a little Fed trip.

Imagine this mathematical formula:

p + i = P


p = the cumulative prices of a specific set of things measured by the Consumer Price Index (CPI) at the beginning of a time period

P = the cumulative prices of those same things measured at the end of the time period

i = the difference between the two

For the lay people, let's play with this:

i = P - p

Divide the whole thing by p and you get the CPI "rate" or r:

i/p = P/p - p/p
i/p = P/p - 1 = r

Example: If an item is priced at $2.25 on 1/1/06 and the same item is priced at $2.36 on 1/1/07, we have:

p = $2.25
P = $2.36
i = $0.11

.11/2.25 = 2.36/2.25 - 1 = .049

Therefore r = .049, or 4.9%

This is a simplified version of how the Federal Reserve calculates the "rate of inflation."

This calculation is an essential part of the process the Federal Reserve uses to determine monetary policy, which in turn is essential to the health of the American -- to wit the global -- economy. To make a long story short, the Federal Reserve determines how much money supply is circulating in our economy by juggling with various means of credit production that I have described in previous posts. (Start with the March 2005 archives for a better understanding of money creation and history.)

Our US Federal Reserve has made a critical assumption in using the CPI as an important element to determine monetary policy. They have assumed that, by selecting a representative sample of items that consumers purchase, they can watch the prices of these items increase or decrease and draw conclusions therefrom concerning the appropriateness of the quantity of money in circulation.

I take issue with this assumption in its present format. Here is why.

The calculations above are great on paper; but they work only as concerns prices p and P for some specific items, i.e. those products the Fed has put into their CPI basket. What about products x, y and z? Is the money supply irrelevant to the p and P prices of x, y and z? Conversely, are the changing prices of x, y and z irrelevant to the money supply?

Remember that in its CPI calculations, the Fed has taken P and p for only those items that are included in the government's list of things to be measured, which list is supposed to represent a basket of consumables that everyone uses. But what if important quantities of consumer dollars are increasingly spent on purchasing things OTHER than those that have customarily been in our government's basket? What if the prices of those things are increasing much faster than the CPI? What does that say about our money supply?

Here's another situation where we get into trouble with our CPI: What if consumers begin to buy products produced outside the country at prices that are temporarily cheaper than they would be at home? This is obviously a good thing for consumers; but what happens then to the CPI, upon which the Fed relies to determine monetary policy? What if the government's basket contains these exceptionally and temporarily cheaper items? (Because it does.)

You will ask, what examples are there of products x, y and z? There are many. For example, x could be stocks of Microsoft Corporation. These are not in the CPI basket. They could be office space. This is not in the basket. Z could be T-shirts from China. And q could be leveraged credit derivatives. And I could go on.

But, you say, I've seen somewhere that the Fed's basket now includes the increased prices of homes, which means that the Fed is taking certain recently ballooning asset prices into account. But I ask you what about the record Dow Jones average? On the othe side of the coin, what about the low prices for Wal-Mart and Target Chinese-made clothing? And what about the trillions and trillions of dollars worth of credit derivatives and yen "carry-trade" speculation now taking place in financial spheres? Are these not consumables? Are these not bought with our money supply? Are these items somehow exempt from Federal Reserve observation? And if so, why?

How do we determine how much of the money supply is being sucked into those? How do we determine if the money supply is adequate -- not too much, not too little -- if we have no way of measuring all prices for all things?

In other words, what happens to the CPI when the prices of certain things expand outside the Fed's radar?

The answers to my questions are unknown, and even the Federal Reserve board of governors would admit this, as strange as that may seem. But then, you ask, why do they persist? Well, I don't know; and I'm not sure that they do either. And thus, in my view, this is where the dung begins to hit the fan.

This is the essence of what I see as the world's biggest economic problem today. A few key central bankers of the world (the US, Japan, China and probably a few others) are ignoring the importance of the price fluctuations of items outside of their basket of goods. These three central banking institutions are the most important money managers in the world, and they are collectively allowing excess credit to circulate around the globe in a manner that is unprecedented, invisible and monstrous.

At some point, this stork will come to roost and lay an egg of inestimable size.

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