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Inflation is greater than you think
Commentary: Focus on 'core' rate is foolhardy
By Dr. Irwin Kellner, MarketWatch
Last Update: 5:00 AM ET Feb 28, 2006

HEMPSTEAD, N.Y. (MarketWatch) -- Don't be fooled: the true pace of price increases these days is not the so-called core rate of inflation, but more like the top-line figure.

When January's consumer price index was released last week, the financial markets breathed a sigh of relief. This is because participants looked past the headline number -- which jumped 0.7 percent -- and focused instead on the core rate of inflation, which was only 0.2 percent above the previous month.

Since the Federal Reserve pays a great deal of attention to core prices, the markets concluded that January's CPI alone was not likely to cause the central bank to adjust upward its eventual target for interest rates.

The Fed likes core prices because, by excluding food and energy, they are supposed to provide a better measure of underlying inflation trends. After all, both food and energy prices are volatile, and tend to be influenced more by the weather and/or by geopolitical developments than by the state of the economy.

I have several problems with all this emphasis on core prices.

First of all, we all use food and energy, so it's pretty clear that what happens to their prices has an impact on our buying power -- not to mention on our attitudes toward inflation.
Second, in recent years, the trend of energy prices has been up -- not up and back down again. This means costlier energy is becoming part of our lives, and has already begun to affect the overall price level through surcharges and other add-ons.

Third, one key reason why inflation looks benign when you strip out changes in food and energy prices is the way the government treats housing prices.

Rather than include the price of a new or existing home the way it does prices of cars, computers or clothing, the government instead uses the rental equivalent. This is because it considers housing an investment, not a consumable good.

Treating housing this way produces an anomaly: the faster home prices rise, the slower the increase in rents. No mystery why: people tend to buy when prices rise, sensing a good investment.
As the demand for owning goes up, the demand for renting goes down. This tends to moderate the overall rise in prices.

January's CPI showed another peculiarity. The cost of medical care went up only 0.1 percent as prices of physicians' services were reported to have fallen by a record 0.8 percent.

Know anyone whose doctor actually lowered his fees last month? Or, for that matter, who did not experience a big hike in his health care insurance premiums?

If you want more proof that the core CPI is lulling people into a false sense of security, take a look at another gauge of prices, the producer price index. Not only did prices of finished goods rise 0.3 percent in January, core prices jumped 0.4 percent -- the largest one-month rise in a year.

This should convince even believers in the concept of core prices that more inflation is headed our way.

-- posted by pbradford6