Lies, Damned Lies and Inflation “Statistics”*

My daughter, who works for the Bank of England, is studying for her Master’s in Economics at the University of Edinburgh, and sent me one of her papers. It was filled with a vast array of complex mathematical equations of which I could make no sense, despite being a mathematician by training and studying Economics at Oxford…..a few years ago.

The Federal Reserve has teams of economists plus input from Reserve Banks all around the country. The Bureau of Labor Statistics, which produces the Consumer Price Index (CPI), has another battalion of experts. All this talent must, one could fairly assume, produce sophisticated and accurate models for inflation.

Imagine my surprise, therefore, to discover that one key element, housing inflation – which constitutes one-third of the CPI and 40% of “core” inflation (excluding food and energy) – is an imputed number (“assigned by inference”), not an actual one.

Read what Nobel prize-winning Economist Paul Krugman wrote recently: ”How does the bureau measure housing inflation? Not by looking at the prices at which houses are sold, which fluctuate a lot with things like interest rates. Instead, it looks at how much renters pay — and for the large number of Americans who own their own homes, it imputes what it calls Owners’ Equivalent Rent, an estimate based on rental markets of what homeowners would be paying if they were renters (or, if you like, the rent they are implicitly paying to themselves).

The trouble is that this measure relies on average rents, which to a large extent reflect leases signed many months ago. A new Fed study shows that official rent measures lag market rents by about a year. And here’s the thing: Market rental rates exploded in 2021, probably as a result of the rise in working from home, but have since leveled off and may in fact be falling.

So official inflation measures are telling us about what was happening a year ago; they overstate current inflation and, perhaps more important, grossly understate the extent to which the inflation picture has improved. If you try to measure inflation excluding those dubious housing numbers, plus other volatile elements, you get a picture of dramatic improvement, almost enough to declare the inflation surge over.”

Let’s look at inflation.There are more gauges of inflation than the UK had Prime Ministers in 2022, but let’s just look at Personal Consumption Expenditures (PCE is the value of the goods and services purchased by, or on the behalf of, “persons” who reside in the United States.).

To prevent lay-people – i.e. those who rely on common sense – from being able to interpret the numbers, the PCE is announced as a Month-on-Month and Year-on-Year change in percentage terms. And, of course, there are other inflation reports that exclude items – like, for instance, food and energy. Now I don’t know about you, but I find that food is essential for my existence, and my house and car both feel the same way about energy

The fascinating thing about the PCE numbers is that, in the detailed report, the actual dollar numbers are published – all the different versions and exclusions. And what is equally fascinating is that the percentage changes announced earlier in the year do not match the dollar numbers that are published.

So having explained that the numbers are, to some extent, meaningless and – like this article – should be taken with a pinch of salt, let me tell you an interesting calculation.

Based upon the figures published on Friday, the increase in the PCE in dollars in 2022 was 7.4% (that is based upon the published dollar numbers, although it was announced as 5% in percentage terms), but in the last 6 months it was only 1.7% – or an annual rate of 3.4%.

I think Krugman may be on to something, especially as consumer spending (seasonally adjusted, of course) has fallen for the last two months.

Imagine you are watching a football game. At half-time your team is losing 17-3. But in the second half it outscores the opposition 24-3. In fact, in the second half, it was able to score almost at will. Thus, while the final score – 27-20 may sound close – a “one-score game” – anybody watching knew that it was not.

Imagine further than when you opened your 401(k) report you read: ”Your portfolio was down 1.2% in the last month, compared with a gain of 0.5% in the prior month. Year-on-Year the decrease was 11.4%. Excluding the effects of currency gains and losses, the seasonally-adjusted Year-on-Year loss was 3.4%.”

You might be tempted to say: ”Yes, but how much is my portfolio worth in – you know – dollars.”

I feel the same confusion about inflation reports. I have just spent two hours going through the 2022 reports and I feel confused rather than enlightened.

My old friend, the brilliant economist Brian Reading, who sadly died recently, once said that to be a successful economist on Wall Street one needed 3 talents: to multiply by 52 if the last statistic was a weekly one, by 12 if it was monthly, and by 4 if it was quarterly. In other words, the assumption was that the future would echo the past.

And I heard an absurd comment by an “analyst” on Bloomberg on Friday that, while the Fed looks at Month-on-Month numbers, it focuses on the Year-on-Year number because “that’s what the public follows.” I paused expecting to hear that the analyst was joking, but he was not.

If all this is even in the ballpark of being accurate, it suggests that the Fed is basing its policy actions on inaccurate and imputed “statistics.”

While the Fed is focusing so intently on the data (“ we know the Fed is data-dependent, we just don’t know which data”, was a priceless comment from Jon Ferro on Bloomberg Surveillance some time ago), it seems increasingly that it is looking at data about the past, whereas it can take up to a year before the full impact of its policy actions is felt in the economy. Thus, we have not yet seen the full effects of the rate increases so far, and the concern of some people – like me – is that the Fed will keep hiking rates – to counter the criticism that it was slow to start raising rates – into a recession, especially as the service sector of the economy is not as sensitive to interest rates as, say, construction or manufacturing.

One more analogy. The economy is like a tanker coming in to dock: it starts to slow down way before it reaches the dock. If it doesn’t, it either has to brake hard (do tankers brake?) or risk ramming the dock. After failing to spot that the dock was in sight in 2021, the Fed has been slamming on the brakes since the middle of 2022. The Fed hopes that its belated rate increases will lead to a gentle docking. Seasonally-adjusted. In percentage terms. Of course.

“Lies, damned lies, and statistics” is part of a phrase attributed to Benjamin Disraeli and popularized in the United States by Mark Twain: “There are three kinds of lies: lies, damned lies, and statistics.” The semi-ironic statement refers to the persuasive power of numbers, and succinctly describes how even accurate statistics can be used to bolster inaccurate arguments.

And read these recent articles:
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• Andrew Oliver, M.B.E., M.B.A.
  Real Estate Advisor
  Andrew.Oliver@Compass.com

m 617.834.8205