Average inflation rate, substitution effect, and other convenient tricks

The FED has recently announced a major policy change: instead of aiming for an inflation rate of 2%, it will aim for an average inflation of 2%. This means that if in some periods the inflation is measured below that value, the FED will allow it to rise above 2% to compensate. Most of you probably do not know it, but this is not the first trick central banks use to manipulate the markets more and more while pretending no distortions on the prices are produced. The most subtle and at the same time simple of these tricks lies in the way they measure inflation.

Let's keep the focus on the FED. The FED uses the Personal Consumption Expenditure (PCE) as inflation index. Why using that index and not the Consumer Price Index (CPI)? There are several reasons, but one in particular is of interest for us now. As you might know, an inflation index is computed as a weighted average of the price changes of a set of goods and services. The PCE and the CPI use two different sets, but the most important difference is that the PCE is computed accounting for the "substitution effect". Basically, this means that if the price of a certain good goes up, but there is a cheaper good the guys who compute the index think can substitute the other (according to them!!), they kick out from the index the good whose price increased and they include instead the good whose price is lower. This of course leads to an underestimation of inflation, although for some reasons obscure to me, the general consensus is that it's CPI which is biased for not accounting for the substitution effect, and not the other way around. So, if there is a certain good you like and you regularly buy, and its price increases, you HAVE to swap it with something cheaper according to those guys. Ehr...ok. Obviously, the CPI is consistently higher than the PCE [1].

I could go on and mention the fact that many goods whose price regularly increases are never included in those indices. For example, in many european countries the price of alcoholic drinks and tobacco doubled in the last 15 years, but this was not even registered in national inflation indices, because they are not included in the set of goods used to compute them. Apparently, those guys are concerned with your health and think you should not consume those goods anyway, so why bother including them?

So, long story short, if you want to know what the real inflation rate is, take the official rates and add 1 or 2 percentage points, and you might get some realistic figures.

This sums it up regarding inflation that affects "real" goods and services. What about inflation on the financial markets? In case you did not notice, we are in the middle of one of the worst economic crisis ever, and stock markets, after an initial dramatic crash, mostly recovered, and the NASDAQ is even breaking new records. "Maybe" it has something to do with the tons of money central banks are throwing in?

P.S. Aside from the questionable way inflation in computed, I think central banks should aim for a 0% inflation rate, but that's another story.

[1] The CPI vs PCE figure was originally posted here.

Will the stock market crash?

 
Now, the million dollar question: is the stock market going to crash? People have been asking this question for the past few years, but so far the market continues its bull run. Some really believe the euphoria is going to end very soon. Granted, sooner or later bearish market will kick in, so if there constantly is someone claiming a correction is going to happen, sooner or later we will see someone "predicting" the crash. Markets go up and down, it's in their nature. Telling when they go up or down is another story. So I really don't want to participate in this pointless game. I do want, however, make a broader discussion about stock markets behaviour.

Let's focus for a moment on the American stock market, which is the one everybody's eyes are on. The S&P and NASDAQ are breaking records, and some say companies are overevaluated by euphoric investors. Still, the american economiy is doing good, maybe not so good to enterely justify such a bull run, but it's certainly not completely irrational. There is real growth behind it. Point is, even stock markets of European economies that are not doing good at all are breaking records. Just to provide a couple of examples, the french GDP growth rate is not exactly breathtaking, and Italy is barely growing at all. However, stock markets in those countries seem to not care; the italian FTSE MIB earned almost 30% last year, despite economic and political instability. So why are the investors so optimist? If I had a fully satisfactory answer to this question, I would already be a millionaire. But I do know one thing: the markets are distorted. Think about it: what do investors base their decisions on? Their outlook on the state of the economy? Yes, also. But what else? Interest rates. Investors are betting that central banks will keep their low interest rates policy indefinitely. They feel safe, because they assume the central bank is there to keep them afloat no matter what. If this is not a distortion, I don't know what it is.

Now another question from finance 101: what is it that goes down when interest rates are low, while the stock market thrives? Bonds yields, of course. Including those of sovereign bonds. This is why there are countries like Italy showing increasingly unsustainable debt to GDP ratios while still managing to get away with sovereign bond yields that are ridicolously low* compared to the seriousness of the economic situation. Too bad, there are no free lunches in this world, so someone must be paying the price, and in fact someone is. But this is only an appetizer. As I mentioned, these policies are distorting expectations, and distorted expectations can create bubbles, that sooner or later have to burst. But I don't want to sound too austrian, so let's assume no bubbles are being inflated. We still have to face the fact that sooner or later central banks will have to raise interest rates. How will the market react? And what about the highly indebted countries? The combination of a recession and increasing bond yields could be fatal for them. Sooner or later the bill for the lunch will have to be paid. Try not to be seated at the wrong table when the time comes.

*Source: investing.com