Here's How I Know the Fed Is Lying Through Its Teeth About Inflation

Lee Adler

Confusion about inflation abounds in mainstream media reporting. That confusion is a result of the fact that mainstream economists and the Fed solely focus on narrowly defined, arbitrarily constructed measures of the prices of consumer goods only. If you only look in places where there's little inflation, or use indexes that are not standardized to measure the same goods over time, you end up ignoring the things that are inflating and understating the inflation that does exist in consumer prices.

The Fed is largely to blame for the confusion. It has targeted a 2% inflation rate. But it uses a benchmark, the core PCE, that is the most understated of inflation measures. It ignores actual housing prices and only includes personal consumption goods. To make matters worse, when an index component is rising faster than cheaper substitutes, the index formula reduces the weighting of the goods that are rising fastest.

The thing is, the Fed is perfectly aware that it's underreporting inflation.

I've uncovered a smoking gun – well, anyway, a chart that proves it knows the real numbers.

The question is – why the cover-up?

I've got my own theories on that (and naturally, a plan of action for you and your money).

First… the "Smoking Gun" That Shows Real Inflation at 3%, Not 2%

Even the NY Fed itself recognizes that these measures, which purport to show inflation falling short of the Fed's target, don't reflect reality. It publishes an unknown series called the Underlying Inflation Gauge (UIG). Since 2012, it has rarely been below 2%, and it is currently at 3%.

Source: NY Fed

There it is, in black and white and tan and blue. The Fed knows. It's just keeping very quiet about it.

Prices Are Rising Much Faster Than the Fed Would Have You Believe

The core PCE may be a measure of how fast some households' cost of living is rising. Maybe those households do substitute similar, cheaper goods when prices rise. But how does that measure actual inflation if it does not measure the same basket of goods over time? If you subtract steak and add hamburger when steak prices are rising, the result is an understatement of the inflation rate of the same goods over time.

The CPI has the same problem. In fact, the CPI was never intended to measure broad-based inflation. It was intended as a basis for indexing of labor contracts and government salaries and benefits. The unstated goal has always been to keep those increases to a minimum.

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On that basis, the BLS removed housing prices from the index in 1982, because raging housing inflation was pushing up CPI too fast. It substituted a measure called Owner's Equivalent Rent (OER) that is completely ginned up. It is supposed to measure what owners think their homes would rent for.

The bottom line is that OER consistently understates the actual rate of home price inflation by at least half, and sometimes more than half. Today, that results in understating CPI by about a full point. When core CPI, excluding food and energy, rises by a reported 1.5% per year, the actual rate would be around 2.5% if house prices were included.

Moving up the inflation spectrum, we see home prices as conservatively measured by the federal government's FHFA index, inflating by 36.5% since 2012. That's 5.8% per year. The NAR index shows the rate even higher than that. FHFA shows the current inflation rate over the past year to be 6.4%. The NAR shows closer to 7%. It is not statistically massaged to suppress the inflation rate as the FHFA measure is.

Not coincidentally, the inflation rate of single-family housing correlates perfectly with the inflation rate of the M2 Money Supply measure. As Milton Friedman famously said, "Inflation is always and everywhere a monetary phenomenon." I would add, "So what if it isn't showing up in the artificially suppressed indexes of consumption goods! It is showing up everywhere else."

Multifamily housing prices are up 55% since 2012 through the third quarter of this year. That's 9.2% per year.

Finally, stock prices have inflated by a sizzling 97% since mid 2012. That's 13.1% per year, including almost 19% in the past 12 months.

Wall Street would argue that earnings per share have risen during that time. So let's normalize for that by looking at the PE ratio of the S&P 500. That's the price of $1 of earnings per share. In mid-2012, the PE ratio of the S&P 500 was 16 (source: Macrotrends). Based on current EPS and price levels, the S&P 500 PE ratio is now approximately 25. That means that the price of $1 of earnings per share has risen by 56% since mid-2012. That's an annual inflation rate of 8.5%.

Of course economists and the Wall Street PR machine never use the word "inflation" in regard to housing or stock prices. To them, it's always "appreciation" or "growth." In reality, there are no purer manifestations of monetary inflation than in these things. The fact that their growth rates approximate the growth rate of the money supply is evidence of that.

It's no accident either that the inflation has mostly shown up in assets. The sole transmission mechanism of central bank money printing, in the United States in particular, is the purchase of securities from primary dealers. The first place the money goes when the Fed buys securities is into the Federal Reserve checking accounts of the world's largest securities trading firms. The financial markets retain most of that cash. After the initial deployment of cash into stocks and bonds, the only trickle down is to the real estate finance industry, where we have seen the results in the massive reflation of the housing bubble.

Securities firms and their corporate clients played games with that money to enrich the corporate capos. Little of it was used to finance real investment, and virtually none of it was invested in labor. In fact, labor no longer has any market power, so it got virtually nothing. Because labor's spending power was held down, so were the prices of goods that they purchase. Because economists and the media look only at consumer prices, it gave the impression that there was no inflation.

But when we look closely, there's still plenty of evidence that prices are rising faster than the Fed and its media handmaidens would have us believe. We know that housing prices are rising by at least 6% a year, when the substitute measure used to represent housing in the CPI is only going up at 2% to 3%.

And we also know that the BLS is understating the consumer goods inflation rate because the underlying wholesale price of consumer goods has consistently risen at a rate about 1% or more higher than CPI.

To illustrate, here's a comparison of various measures of consumer prices.

While core PCE is rising at only 1.4%, and core CPI at 1.7%, the wholesale prices of core finished consumer goods are going up at 3%. These prices are volatile, but a gap of 1% in the inflation rate between wholesale and retail is typical. Would government statisticians, the Fed, and Wall Street shills have us believe that retailers never pass along their rising costs?

I don't know about you, but I don't believe it. Amazon and Walmart wouldn't stay in business for long if they did not pass along their cost increases.

The Fed Senses Danger – and Actions Speak Louder Than Words

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Lee Adler

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Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.

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