Thursday, November 25, 2010

On the news and other nonsense.

Under the "people say the darnedest things" heading

According to a friend, “Glenn Beck said that the government, using administrative rule rather than a law, had changed the index for CPI. As a result, people on SS would for the second year not get an increase, or COLA.”

If Glen Beck says the reason for no increase in SS is that food and energy are excluded, he is wrong. SS is based on the CPI which includes food and energy along with housing, entertainment, medical, everything in the "average urban basket of goods." The reason SS did not get a cost of living increase is because the CPI increase didn't exceed the threshold for an increase. Not to worry...there is a bill to send SS recipients $250 each since they got no COLA increase.

The practice of looking at the CPI excluding food and energy is common among serious analysts because of the volatility of food and energy. (To get at trends, they often smooth food and energy monthly numbers using a moving average). Consumers tend to do the opposite. They focus on food and energy way beyond their importance in a budget. Part of it is the fascination with things that move. The volatility makes it seem important. Just think about what the average consumer spends on housing, insurance, and total auto expense verses food and energy. (I know people who spend more on phone, cable, and other entertainment than on food). Food and energy seem important because they change frequently. Real estate taxes, mortgage, insurance premiums, or rent payments, the price of a new car or major repair to home or auto are less frequent.

The law has nothing to do with it. The CPI is subject to administrative changes. There isn't any law governing how it is calculated. The BLS does a survey to determine the basket. The basket determines how much changes in food and energy as well as everything else are weighted in the index.

The big changes, however, are: adjustments to the weights assigned to different things (food, housing, etc.) in the calculation of the index, and adjustments for quality changes. The weights matter because when the basket changes, the older historical data became useless, questionable, or fantasyland. Historically, since there wasn’t an alternative (other than the GDP or Consumer Expenditure deflator in the quarterly National Income and Products Accounts) people used fixed weight CPI anyway. So, BLS publishes a chain-weighted index, but people in the media use whatever index supports their story rather than the one that is relevant. Chain weighting involves a lot of mathematical gobbley-guck. Technically, chain weighting is more reasonable for longer periods of time.

The real problem is that people confuse the “cost of living” and “prices changes.” The CPI methodology has fallen into the same trap. The net effect has been to show that inflation was lower than what results from fixed weights. If you want a conspiracy, pick chain weighting. However, the real dirty trick is how they treat substitution and “quality changes.”

I, by the by, think the net result is masking short-run changes (i.e., month-to-month, year-to-year). Also, I am pretty sure the government did it intentionally. After all, one of the reasons for the switch to chain weighting and adjusting for quality changes was that ignoring quality improvements results in changes that are “too big.” But, that’s different from saying they did it with malice.

Which is real? Well, if the quality improvements matter to you, your answer will be different from someone’s who doesn’t care. I figure they knocked at least a percent off the CPI, maybe two. But, that judgment is subjective based on my assessment of the value of the quality changes and the relevance of the changes in the basket.

Regarding quantitative easing and hyper inflation, deflation, inflation and such, you’ve asked about the money supply from time to time. People insist upon believing the FED controls the money supply, even some people at the FED believe it. Simple fact is the FED lost control of the money supply, if they ever had it, many, many years ago.

To illustrate, one can call the extension of credit a measure of velocity of money or the creation of money, but it doesn’t matter in terms of economic impact. It creates more money. But, the FED only controls this through bank reserves. Banks are only half the story (quantitatively less than half). The shadow banking system’s credit extension passed depository institutions in about ’95 and by ’99-2000 had left it in the dust. With the financial panic, the biggest single creator of money, the bond market, stopped creating money.

Securitizations are still pretty anemic. Somewhere close to 6 trillion dollars in credit disappeared from the economy as a result of the decline in securitizations. I figure 600 million in QE2 is a drop in the bucket. If the FED can’t get people worrying about inflation, QE2 won’t help enough to be important. If they do get people worrying, they have to figure out how to undo it fast. The danger is people will wake up and realize the FED isn’t all powerful.

On the political right, there seems to be a concern about the FED just printing money. Well, that’s where money comes from. As to their buying government bonds, they buy short-term Treasuries to control the federal funds rate (i.e., set interest rates). That is what open market operations are all about. It’s not new.

What is different, and the issue with QE2, is that now they are playing with the shape of the yield curve (e.g., the spread between over night loans verses 5, 7, and 10 year bonds) since they are buying across multiple maturities. That’s dangerous, and they know it.

There are times I think the big tactical (i.e., political) mistake was couching QE2 in dollars. For open market, and thus short term rates, they announce it in terms of a target interest rate, not dollars.

So, my forecast is different from The Trader’s “inflation will inflate.” The risk is that the FED is pursuing self-contradictory policies. We’re in a much more unstable situation as a result. It’s like during the housing bubble when I just kept saying this is not a situation with a stable equilibrium. Quite frankly, however, I worry less about FED policy than the other nuts in the government.

Beck’s forecast of a lot of inflation doesn’t say much. Is 70’s style stagflation a lot, or are we talking 5%, or the central European wheel barrels of money stuff? Any one of them as well as deflation are possible outcomes of QE2. But, the FED could get it right and the recovery could just keep chugging along. I think they’ll overshoot slightly and inflation will have to be reigned in, but that’s based on a lot of ifs.

Regarding SS COLA’s, there is no provision for cutting benefits if prices fall. If you’re retired, “here, here, and three cheers for deflation.” But, for the rest of us: if you want a justifiable rant, try to figure your taxes THIS year, not to mention next year. You can’t!!!! The AMT will catch a big part of the middle class if they don’t pass a fix and soon. I’ve had to do tax estimates both ways. It’s a big difference. Now, which do I use to pay this quarters estimated tax? No one knows.

Think it doesn’t matter since you withhold. Well, as they say, “think again little grasshopper.” If they let it go to fix later, the IRS will have to calculate withholding rates for 2011 based on “no fix” and no extension of the current tax rates. Every wage earner will see it in their first paycheck of 2011.

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