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The key issue in financial markets is once again the inflationary threat. The discussion subdivides into a) is there such a threat?; b) how serious is it?; and c) what should be done about it?.
What is undeniable is that the rate of inflation has risen dramatically in recent months, and substantially over the past year. The debate is focused on the US because the policy response of the Federal Reserve Bank will be the critical factor in determining how global financial markets move.
However, it is important to note that concerns over rising inflation are not limited to the US. The European Central Bank is also worried, and might even raise interest rates on the euro. The British are less worried because consumer demand in the UK is clearly weakening, so interest rates there may be cut (again). The Japanese are actually hoping to see some inflation, which for them will be wonderful news after years of deflation. Canadians, on the other hand, are already raising rates.
The widespread concern reflects the fact that the main factor behind the rise in inflation has been a universal one - relentlessly higher oil prices. These have generated extraordinary jumps in US price indices at both the producer and consumer levels. On the face of it, therefore, there is no scope for disagreement: inflation is sharply higher and is therefore a serious threat.
Or perhaps not. The introduction of the concept of "core inflation" - usually referring to the movement of the price index, not of volatile items such as energy and food - has redrawn the parameters of the debate. Jumps in the price of oil, or other transient events, do indeed generate higher inflation at the "headline level" - meaning the overall Consumer Price Index, prominently reported in the media and hence responsible for how the public perceives inflation. The September CPI in the US, for example, was 1.2% - the highest single-month rise since March 1980. The two preceding months saw rises of 0.5% each, so the annualized inflation rate in the third quarter was a horrendous 9.4%.
But the driver behind the September surge was the 12% leap in energy prices; "core" inflation was only 0.1%, and has been consistently low. So it can be argued that there is no inflationary surge, and hence nothing to get excited about. More specifically, there is no reason to raise interest rates aggressively to head off the "inflationary threat" because there is no such threat. Indeed, there isn't really any inflation.
OR PERHAPS there is. Since inflation is measured by price indices, it all depends on how you construct these and what you put in them. For example, until 1982, the US government measured the housing component of the CPI via actual house prices. It then adopted the more sophisticated - and more logical - approach called "owners' equivalent rent of primary residence," which measures the value of a home to its owner by calculating what he/she would pay in rent and other ongoing expenses, rather than what the unit would sell for. (Israel made a similar move in the mid-1990s).
Currently, housing represents 23% of the basket of goods and services that comprise the American CPI. If the pre-1982 system was still in use, the rate of overall inflation would be 5.3%, while the rate of "core" inflation would be 4.3%. Of course, you could take housing out of core inflation as well, to get a different kind of core and hence a different answer as to how high inflation is (the Israeli Central Bureau of Statistics publishes "CPI ex-housing" as a matter of course).
A leading American analyst, using data for the first quarter of 2005 (the above data relate to the third quarter), concluded that distortions caused by not factoring in the housing price boom and the rise in property taxes result in the official rate of inflation understating "actual" inflation by over 4%!!
But professional statisticians and economists would claim that it is wrong to define "actual" inflation on the basis of the recent boom in house prices. Imputed rental values, which are much less volatile, give a much better picture of the underlying trend, and prevent impetuous wrong conclusions. Yet try telling that to real live consumers, for whom housing prices involve actual money. True, they don't buy houses on a weekly or monthly basis, but they do buy gas for their cars and heating oil for their homes on that basis, so what justification is there for saying that the rise in energy prices, underway since mid-2003, can be excluded from "core" inflation because energy prices are "volatile"?
Then there is healthcare. In the real world, this represents 17.5% of consumption and 15-17% of GDP, but its weight in the CPI is just over 6%. As everyone knows, healthcare costs have been rising rapidly for years, and the trend is getting worse. If these costs were properly weighted, the CPI would be much higher, inflation much worse, and both short-term interest and long-term bond yields would be much higher.
In short, defining what prices an inflation measure (i.e. price index) should include and how to measure them is a conceptual and practical minefield. In an age when governments of every political leaning and ideological stripe distort data to promote their own interests, it is hardly surprising that they present price indices and inflation data in the manner best suited to their perceived needs.
By the same token, in an age of near-universal cynicism on the part of citizens toward governments, and of people in general toward authority in general, it is entirely natural for official inflation data which are wildly at odds with the reality faced by consumers and businesses to be regarded with disbelief.
That is the issue that should be exercising policy makers as well as independent analysts. It should certainly be high on the agenda of the Congressional hearings regarding President Bush's candidate to be the next chairman of the Federal Reserve.