NEW YORK (Reuters) - U.S. inflation appears to be ebbing as the economy slows, but the trend may have more to do with systematic undercounting than newfound purchasing power.
The gap between policy-makers' price barometers and the reality experienced by consumers is nothing new. Americans are often bemused by headlines saying inflation is under control even as their cost of living seems to keep climbing.
Yet this divergence has implications beyond puzzled news readers. Monetary officials know that misjudging inflation could result in an acceleration of price increases that might prove difficult to rein in.
This is why the Federal Reserve continues to express greater concern over a pick up in inflation than an economic downturn, even as the markets forecast just the opposite.
Barry Ritholtz, chief market strategist at Ritholtz Research & Analytics, says an obsession with measures that exclude such basics as food and energy has led to a misguided assessment of price pressures.
"Focusing on core inflation is an absurd exercise," said Ritholtz. The growing disconnect between overall inflation and the core measure reflect just how questionable some of these readjustments have been, he added.
While core numbers can be of some use in smoothing out month-to-month fluctuations, they make less sense on a yearly basis. "If it's happening from one year to the next it's a trend, not a blip."
CHERRY-PICKING
Yet this is exactly the figure the Fed has implicitly adopted as its goalpost for policy, putting the U.S. central bank at odds with some of its major overseas counterparts.
The history of this shift can be traced back to the oil crises of the mid-1970s. Then Fed Chairman Arthur Burns asked economists at the central bank to strip out energy from the CPI to get a clearer picture of underlying price trends.
Now, though, some of the practice's biggest critics contend that what began as an innocent enough exercise in minimizing distortions has evolved into the gradual removal of politically unpalatable rises in costs.
"The reason the government changed the way they calculate inflation is because they didn't want the public to know how bad inflation really is," said Peter Schiff, president of Euro Pacific Capital.
THE CRUELEST TAX
Paul Volcker, the former Fed chairman widely credited for putting the clamp on the runaway inflation of the 1970s, once referred to rising prices as "a cruel and maybe the cruelest tax, because it hits in an unexpected way, in an unplanned way, and it hits the people on a fixed income hardest."
"And there's quite a lot of evidence, contrary to some earlier thinking, that it hits poorer people more than richer people," he went on.
In this context, inflation pressures that go unaccounted for might help explain an increasing squeeze on the American middle-class, which many analysts feel is too deeply in debt to cope with a possible economic downturn.
John Williams, a private consulting economist who got so tired of looking at the official figures that he started compiling a set of his own. Using the same methods the government employed in 1980 Williams estimates that inflation is actually running around 10 percent per year.
That's a far cry from inflation readings reported by the government, which are currently hovering between 2 percent and 3 percent.
If Williams is right, it would mean the dwindling number of Americans who still manage to sock some cash away in a savings account at the end of the month are actually losing money in real terms.
By shifting its attention away from a constant basket of goods to one that allows for the substitution toward cheaper items, officials at the Fed effectively redefined inflation.
"Now you're looking at a cost of living for a declining standard of living," said Williams. "But people want to be able to maintain a standard of living."
Even if one does take the official statistics at face value, global forces like rising commodity and energy prices are likely to keep a floor under prices, say analysts.
That, in turn, might make the concept of core inflation as a guide to monetary policy look increasingly irrelevant. It would also complicate the Fed's task of managing consumer expectations about inflation, considered key in the fight against accelerating price gains.
"With globalization so dominant, and Chinese and Asian appetites for oil, soybeans, and iron ore amongst other commodities so voracious, it's hard to envision an extended period of lower headline U.S. increases," PIMCO Managing Director Bill Gross told clients in his latest outlook.
"This may bias more central banks to begin considering headline numbers in their policy decisions, like Japan and the European Central Bank do already."
Until then, Americans will remain befuddled by inflation news that flies in the face of their own experience.
