One would think that after the worst financial crisis since the Great Depression, Americans could at least catch a break for a while with deflationary forces keeping the cost of living relatively low. That’s not the case.
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“The Federal Reserve continues to focus on the rate of change in inflation,” said Peter Bookvar, equity strategist at Miller Tabak. “Sure, it’s moving at a slower pace, but the absolute cost of living is now back at a record high in a country that has seven million less jobs.”
The regular CPI, which has already been at a record for a while, increased 0.5 percent, the fastest pace in 1-1/2 years. However, the Fed’s preferred measure, CPI excluding food and energy, increased by just 0.2 percent.
“This speaks to the need for the Fed to include food and energy when they look at inflation rather than regard them as transient costs,” said Stephen Weiss of Short Hills Capital. “Perhaps the best way to look at this is to calculate a moving average over a certain period of time in order to smooth out the peaks and valleys.”
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The so-called core CPI is used by the central bank because food and energy prices throughout history have proven to be volatile. However, one glance over the last two years at a chart of wheat or corn shows they’ve gone in one direction: up. And many traders say Fed Chairman Bernanke’s misplaced easy money policies are to blame.
Over time, the Bureau of Labor Statistics has made changes to the regular CPI that it feels make it a better measure of inflation and closer to a cost of living index. It improved the way it averages out prices for items in the same category (e.g., apples) and also uses the often-criticized method of hedonic regression (if you're curious, you can learn more about that here) to account for increases in product quality.
In 2002, the BLS created this often-overlooked cost of living index in order to account for the kinds of substitutions consumers make when times are tough. It is supposed to be even closer to an actual “cost of living” measure than the regular CPI.
“For example, pork and beef are two separate CPI item categories,” according to the BLS web site. “If the price of pork increases while the price of beef does not, consumers might shift away from pork to beef. The C-CPI-U (Chain Consumer Price Index) is designed to account for this type of consumer substitution between CPI item categories. In this example, the C-CPI-U would rise, but not by as much as an index that was based on fixed purchase patterns.”
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“As the cost of living increases, we are headed toward a bigger problem with the slowing of housing permits,” said JJ Kinahan, chief derivatives strategist at thinkorswim, a division of TD Ameritrade. “As the staples start to cost more, this could lead to a quick slowdown in the auto and technology sectors as an iPad is an easy thing to pass on if you are paying more for your gas and food and need to cut back somewhere.”
To be sure, it’s nearly impossible to get a perfect “cost of living” measure, and the BLS acknowledges this on their web site: “An unconditional cost-of-living index would go further, and take into account changes in non-market factors, such as the environment, crime, and education.”
Still, states will be cutting back services drastically this year at the very same time they are raising taxes in order to close enormous budget deficits and avoid a muni-bond defaults crisis. So while it may be the missing link to a perfect cost of living measure, one can assume that Americans will be paying more for unquantifiable services such as police enforcement and education, but getting them at a lesser quality.
Bottom line: The cost of living for Americans is now above where it was when housing prices were in a bubble, stock prices at a record, unemployment low and consumer confidence was soaring. Something has gotta give.
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