A fascinating, recent report by the Devonshire Research Group, whose recent work on Tesla was featured here one year ago, has moved beyond the micro and tackled on of the most controversial macroeconomic topic possible: what is the true rate of inflation. What it finds is that, like others before it most notably Shadowstats and Chapwood, the accepted definition of inflation, or CPI, is dramatically understated for various reasons, both political and economic.
For those unfamiliar with the "alternative" explanations of inflation measurement, and the implications if CPI is indeed drastically underestimating true inflation, the report is a real eye opener.
Devonshire sets the scene by noting that a wide variety of Price Indices are used to adjust for the effects of Inflation on the economy. These adjustments are widely applied to derive a number of common measures and underlie many critical economic and asset management concepts
- Price Indices: the Consumer Price Index (CPI), the Producer Price Index, the GDP Deflator
- Economic concepts: the Standard of Living, Real Income and Output, Real Economic Growth
- Asset Management concepts: Real Interest Rates, the Risk-Free Rate of Return, the Cost of Capital
These indices and concepts are intimately commingled which is leading to a wide ranging divergence between reality, published government statistics and the assumptions used for investment decisions.
So how did the US economy end up with the current version of CPI, and specifically why is the widely accepted measurement methodology so wrong? A rising tide of Contrarians and their measurement methodologies is arguing that Inflation is understated by the Price Indices chosen by U.S. government agencies in numerous ways for complex reasons
- The CPI fails to measure a simple basket of goods that consumers typically purchase “out-of-pocket”
- The weights in the official baskets shift over time in ways that mute the impact of higher priced products
- Price increases attributed to quality improvements (hedonic adjustments) are subjective and overstated
- U.S. government agencies have incentives to downplay CPI increases to lower cost-of-living payments, reduce borrowing costs, and increase apparent real economic growth
The Consensus of Contrarians is growing, shared across several independent critics and supported by concerns among many that official statistics paint on overly optimistic picture of the U.S. economy.
Needless to say, if and to the extent that the Contrarians are correct, the implications for the U.S. economy and for investors are profound
- The Standard of Living may be far more difficult for many Americans to maintain than published statistics suggest
- Real Economic Growth may be flatter or actually negative, suggesting a prolonged 21st century recession, not recovery
- Real Interest Rates, already seen at historic lows, may be strongly negative making Fixed Income returns unattractive
- The Cost of Capital most commonly used to measure investment returns may be far too low
The Consensus of Contrarians suggests that many investors are using incorrect assumptions in their asset allocation models and investment decisions. Capital preservation is compromised, portfolio allocations are distorted and return performance is overstated. Devonshire's preliminary conclusion: the broader effect on capital markets is likely profound and complicated.
Follow some of the key charts and supporting materials to demonstrate just how off CPI is from its measurement of reality, but first a bit of history: the CPI was originally designed as a tool to adjust wage increases:
The Consumer Price Index was initiated during World War I (which the U.S. joined in 1917) and was later estimated back to 1913. Due to the war, prices were rising rapidly as the government was pouring money into shipbuilding centers, this made it essential to have an index for calculating cost-of-living adjustments for wages.
A brief history of the Consumer Prive Index, and its several relatives:
Eventually, as the US Government developed a stronger interest in inflation, its incentives rose to steer CPI outcomes downward
As noted above, the reason why inflation measurement and reporting has become so controversial is that it is "less a measure of purchasing power (and therefore a financial tool), and increasingly a process of affecting macro-economic policies (and therefore a policy lever)." Just see Venezuela which recently stopped reporting inflation altogether to avoid rising social disorder and anger.
The report goes on to note that while in recent decades, transportation/energy components of prices have seen dramatic fluctuations as a result of oil crises, and subsidy programs, if one treats “transportation” and “other” as exceptional assets, and follow only US gov’t stats, the modern investment age has the feel of stability. In fact, viewed from a longer perspective, the rate of inflation, once volatile from year to year, “flattened” out to the “accepted” 3% / year
Alternatively, Contrarian views of CPI return to its fundamentals: what is the Consumer Price Index:
While the chart above lays out the theoretical divergences, the next chart shows just how vast the differences in CPI are in practical measurement terms between the official CPI calculation, and several alternatives.
Some of the alternative measurements include the Shadowstats Index, introduced in August 2006, the Chapwood Index, whose first publication used the 2012 price inflation, and the Now and Futures CPPI.
Why the emerging disparity? According to Devonshire, numerous arguments claim that the CPI has undergone intentional algorithmic, measurement changes. These are shown below:
The biggest difference in methodology: the CPI no longer tracks Standard-of-Living, and Out-ofPocket Expenses, yet is still used to benchmark salary increases.
Follows the most important chart: the estimation of real annual inflation: according to Devonshire, that number is roughly 8%, nearly three times higher than the "accepted" rate of 3%.
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So why does the government under-represent inflation by such a vast order of magnitude? Simple: if you claim a lower CPI than in practice, you don’t adjust wages upwards as appropriate, so you save money 24
"It is estimated that between 1996 and 2006, this reconfiguration of the CPI saved the US government over $680 billion." - Chapwood
So putting things in context, as a reminder, total cumulative inflation measuring a “fixed bag” of “standard quality of life” over time – this is the official BLS view.
Meanwhile, the contrarian views of Shadow Stats, CPPI and Chapwood of total cumulative inflation since 1940 are far more bleak. The chart reveals two things
- The discrepancy suggests a 4-5x less purchasing power today that the “official” view
- And the contrarian views of total cumulative inflation suggest 5-20x less purchasing power now than in 1970
Implications for both the economy and investing are profound, here are just two of them, first, for real GDP: the contrarians suggests the US economy never recovered fully after the dot-com bubble and ’01 recession 30
Meanwhile, investors should ask themselves what is the true “risk-free” rate of return, if inflation adjusted treasuries lose 7-8% purchasing power annually?
Devonshire's summary conclusions:
- US official CPI calculation is governed, and possibly distorted, by numerous and complex technical decisions
- Inflation reporting is less a measure of purchasing power (and therefore a financial tool), and increasingly a process of affecting macro-economic policies (and therefore a policy lever)
- Real gross domestic product (GDP) measures, yield curves, and treasury issued inflation protected securities (e.g. TIPS), government and union / minimum wages all rely on official US inflation indices that are subject to these distortions
- Most financial, wealth management models rely on a price stability assumption and default to 3% inflation input – what would happen to these models if the true value was closer to 7-11%?
- If we re-compute a purchasing power CPI, de-sensationalize contrarian reporting, and remain disinterested with modern economic policies, we arrive at a 7-9% practical CPI rate over the past decade
- This has profound implications on reported vs. actual standard of living, and might explain the rapid appreciation of American consumer debt, potential reduction in perceived vs. reported quality of life, not to mention unexpected political trends
- Post-1990 inflation of 7-9%, not 3% would also suggest near “bubble-like” conditions exist across many consumer sectors;
Expect low-cost consumer non-durable, consumables, food, housing, clothing, retail to continue to exhibit strong cost pressure and consolidation incentives – or a macro-recession causing a major “inflation adjustment black swan event”
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Full presentation below: