The Right Way to Measure Inflation and Real Interest Rates

In which Dr. John advises you to skip FOMC meetings but show up for earnings calls, suggests that asset prices are the right inflation index, and why you should bet against the Fed.

The Book Project

At my age, I have more stories to tell than time to tell them, so I have decided to make posts shorter stories a little more often. (After this one, which is too long!) I am also working on a book that will contain both an explanation of the analytical framework behind the things I write and how I invest and will have all of the personal stories I can stuff between two covers. My analytical model has two states: 1) an asset-centric general equilibrium state to use when networks are intact and financial markets are open for business, and 2) a second, far-from-equilibrium state representing a temporarily damaged economy after a cascading credit network failure, connected by phase transitions between the states. (Whew, that was a long sentence.) It is followed by an explanation of the dynamic investment strategy that makes sense in this two-state world. I’ll be sending you draft bits of the book along the way and welcome your ideas and comments.

Why I Skipped the FOMC Meeting

Now to the serious stuff. Two letters ago, I advised you to forget the Fed so I didn’t watch Wednesday’s FOMC Press Conference week because I have better things to do than count how many times Chairman Powell used the word “the” in his Q&A session with the child-journalists. Besides:

• We all knew what they were going to do — nothing.
• We all knew what he was going to say — “We’re the roughest toughest bunch of inflation fighters in the building.” (wink, wink; nudge, nudge)
• We all know what they will do next — make the first of many quarter-point rate cuts.
• We all know they will never admit that their bogus inflation measures—the CPI and PCE—both overestimate inflation. Both indexes overweight housing costs by including a made-up figure called Owners Equivalent Rent (OER) that shouldn’t be in the indexes at all. By my calculations, corrected measures excluding OER have already reached the Fed’s 2% target. Excluding OER, the February CPI was just 2.1% and the January PCE inflation was 1.7%.[i]
• And we all know they won’t cut rates until their bogus inflation measure drops by another half percent or so, or an unpleasant regional bank commercial real estate event triggers a liquidity problem that forces their hand. (I’m betting on the latter.) Fact is, the exact timing of the first rate cut isn’t very important so I’ll be skipping the next FOMC meeting too because I have to wash my socks that day.

The Wrong Index

So, if the CPI, the PCE and their many variations (headline, core, super-core, trimmed-mean, inflation-NOW, etc.) don’t do the job, what should the Fed use to measure inflation? Sadly, none-of-the-above.

Even after fixing the OER issue, neither the CPI nor the PCE measures the things the Fed should worry about when calculating real interest rates, measuring inflation expectations, or setting policy. The CPI and PCE only attempt to measure the prices of the goods and services that are currently being produced in the GDP accounts; they completely ignore the prices of the assets and liabilities in people’s balance sheets.

In fairness, one reason the Fed targets consumer prices is because Congress told them they had to do it. In 1977, Congress gave the Fed a dual mandate to pursue both maximum employment and stable prices. The stable consumer prices part of their mandate is largely political, which is why Chairman Powell mentions how painful it is for people when prices rise at every press conference. And since some economists believe that a little inflation, but not too much, helps lubricate the wheels of commerce to keep the economy near full employment, the Fed has chosen 2% as its magic target number.

The Right Index

In my analytical framework, the Fed needs to keep prices stable for a different reason—to protect the long-term purchasing power of the dollar and make sure that our massive asset markets serve as a source of growth, not instability, in people’s lives. To do that they need to look at asset prices.

According to the Fed’s most recent Z1 report, on 12/31/23 the U.S. balance sheet contained $349 trillion of financial assets (p. 3), $163 trillion of tangible assets (p. 8), which makes total assets of $512 trillion (18.7x GDP), and has a Net Worth of $144 trillion (5.2x GDP).[2]

For comparison, Households and Nonprofit Organizations (p. 140) owned $119 trillion of financial assets, $58 trillion of tangible assets (mostly houses), for total assets of $177 trillion, and owed $21 trillion in liabilities (mostly mortgages), for a Net Worth of $156 trillion, which is 5.7 years worth of 2023’s $27.4 trillion GDP, and 7.7 years of 2023’s $20.2 trillion Disposable Personal Income.[3]

The Fed’s decision to ignore asset prices is a mistake for two reasons. First, from the standpoint of household welfare, fluctuations in the income and capital gains from those assets have massive effects on consumer welfare. Second, and more importantly, fluctuations in asset prices trigger changes in investor behavior that can undermine capital spending and reduce long-term growth.

Excluding ill-advised Open Mouth Operations (speeches), the Fed has one big weapon—the size (dollar value) of the assets on its balance sheet. By controlling the size of its balance sheet the Fed influences the price (and therefore the yield) of the Treasury bills, Treasury bonds, and other assets it holds and determines the stock of bank reserves that influence lending and deposits. It is by driving changes in asset prices, lending, and deposits that the Fed exerts its influence on the economy and on people’s lives.

Some of those effects are obvious. When the Fed sells some of its securities (as they are doing now with QT), they drive security prices down and yields up, which makes people earn more on their Money Market Funds and makes it more expensive to buy cars and houses on credit. They also reduce bank reserves, tighten lending and shrink bank deposits (the money supply). The resulting changes in consumer and business spending is what the Fed’s models are trying to predict.

Some are not so obvious. Households don’t only own Treasuries and other financial assets; they also own $58 trillion of tangible assets, more than 80% of which is real estate. Tangible assets have returns, just like T-bills, part of which is the capital gains owners earn when property prices go up (inflate). And changes in tangible asset prices are the principal drivers of changes in household net worth.[4]

Tangible Assets are the Biggest Game in Town

This makes tangible asset prices the biggest game in town. And it makes swings in tangible asset inflation — the capital gains yield on the public’s $163 trillion stock of tangible assets — a massive potential source of instability for the economy and financial markets. A sharp increase in tangible asset inflation, drives a wedge between the returns on real and financial assets. This can lead to a rebalancing of portfolios that pushes stock and bond prices lower, interest rates higher, and reduces both capital spending and long-term growth. And a sharp drop in tangible asset inflation can cause the reverse, pushing stock and bond prices higher and shutting down the housing market. All of which makes real asset inflation a more desirable Fed target than consumer prices.

This also makes real asset prices the appropriate index to use when calculating real interest rates. I concluded long ago that the only positive statement economics has to make is the Law Of One Price (LOOP) stating that people will arbitrage away price and return differentials, which is simply a restatement of the second law of thermodynamics.

The reason real interest rates are interesting is that they are supposed to represent the difference between the return on holding financial assets and the return on holding consumer goods over the coming year, which should influence people’s behavior. That works for real rates calculated by using real asset inflation because you can hold real assets over the next year. But it doesn’t work for consumer prices because 70% of the market basket of goods and services used to construct the CPI are services like haircuts and guitar lessons, or nondurable goods, like lettuce and popsicles, that disappear from your market basket before the year is over.

It goes without saying that if real asset inflation is the appropriate metric for portfolio behavior and real interest rates, it is also the right metric for expected inflation. Both surveys conducted by asking people what they think CPI inflation will be over the next year and so-called forward expectations measured by using the market price of TIPS (pieces of paper that promise to pay the owner a capital gain based upon the realized value of the CPI at a future date) fail the arbitrage test discussed above.

Time to Bet Against the Fed

Alas, both the Fed and the economics profession are firmly locked into using the CPI. But that’s OK because it gives me the opportunity to bet they are wrong when I believe they are making a mistake.

I believe they are making a mistake right now. The Fed’s fixation on targeting the CPI and PCE (including the demon OER) is causing them to overstate both inflation and expected inflation and to understate real interest rates, which is making them keep rates too high, too long. If I am right, they will be forced to end QE and push rates sharply lower over the next year as the incompatibility between current interest rates and today’s real asset prices become clear, providing an attractive buying opportunity for patient, liquid investors.

What To Do

I’m an investor, not a trader, so I don’t make meaningful changes to my portfolio based on the latest economic report. Instead, I base my investment decisions on the 30,000 foot view of the economy and markets for 2024 that I summarized for you a few weeks ago. Here’s a summary:

• Global politics are a mess and are certain to get worse between now and the election. The pandemic scared people to death, setting the stage for the proliferation of thugs, autocrats, and totalitarian rule that has followed every plague in history.[i] Autocrats thrive on tribal conflict and make big messes.[ii] So portfolios should be even more defensive next year than last year. Hold more cash than you think you will need so you are liquid enough to buy cheap assets from others who are forced to sell. You will forego a little of the money you could have made by owning even more NVDA and LLY shares, but you will sleep better.
• Regarding the economy, forget the Fed “Dot Plot.” Inflation and interest rates will surprise on the downside. Spending, growth will surprise to the upside.
• Stock prices will increasingly reflect company performance, not Fed policy. (We can skip the FOMC meetings but not the earnings calls.) That means investors will have to pay more attention to Intrinsic Value and Intrinsic Risk than to macro factors. More on how to do that in my next post.

As always, I welcome your comments.

Dr. John

[1] In case you are interested in the calculation. The February headline (All Items) CPI inflation came in at 3.2% but OER inflation (6.0% from a year earlier) has a 27% weight in the index, which makes the inflation rate for the 73% “rest of the index” (3.2% – .27 * 6.0%) / .73 = 2.1%. By a similar calculation, January PCE inflation came in at 2.4% but OER inflation (6.3% from a year earlier) makes up 15% of the index, which makes the inflation rate of the remaining 85% of the index that represents actual expenses for consumers (2.4% – .15 * 6.3%) / .85 = 1.7%.

[2] IMHO, the U.S. figures for Tangible Assets, Total Assets, and Net Worth in the Z1 report are too small. For some (non-GAAP) reason, the Federal Government reports all of its liabilities (the national debt) but excludes the value of all land and other non-reproducible assets (oil, gas, coal, timber, etc.) from its balance sheet on the flimsy logic that they don’t, like, actually ownt hose assets, they just, like, hold them in trust for future generations. How big are the things they don’t report? Last time I checked the Federal government owned more than 700 million acres of land including most of the land west of the Rocky Mountains and a chunk of Waikiki Beach! Based on their logic, I have decided to exclude the value of my house, the land under it, and any other non-reproducible assets from the numbers I send the tax authorities next month on the basis that I am just holding them in trust for my children and grandchildren. Wish me luck!

[3] But wait, there’s more! Both GDP and Household Disposable Personal Income are too high as well. Both are artificially inflated by improperly including about $2 trillion of imaginary Owners’ Equivalent Rent (OER) in their construction. Excluding OER would reduce both figures (along with Consumer Expenditures, Personal Income, and Per Capital Income) by roughly 10%.

[4] The net worth of the U.S. is the sum of the market values of all tangible assets, less net foreign liabilities, as shown on p. 8 of the Fed’s Z1 report. Why just the tangible assets? Because, according to Fed, financial assets are completely offset by financial liabilities when consolidating balance sheets. IMHO there is a good question about how to treat the value of equities. A sensible approach would be to add the value of equities in excess of book value to the net worth figure, which would increase reported net worth by about a third above currently reported levels.

[5] From the wealth of material on plagues, pandemics, and immunology on my bookshelves my top two recommendations are Plagues and Peoples by William H. McNeill and Pox Romana by Colin Elliott. (I will write about these books in detail in a later post.) McNeill’s book is the definitive history of pandemics—the dynamic evolution of complex systems comprised of interacting populations of microparasites (bacteria and viruses) and macroparasites (humans) that was made possible when irrigated agriculture produced a food surplus large enough to support cities of sufficient density to give both groups of parasites permanent homes.

McNeill traces plague from its first recorded appearances in Babylonia and Egypt (2000 BC), to China (1300 BC), through the Plague of Athens (430 BC) that decided the outcome of the Peloponnesian War, through hundreds of plagues in history up to and including the AIDS epidemic. Elliott focuses on the history of plagues in the Roman Empire starting with the Antonine Plague (smallpox) that effectively destroyed the Roman army during the time of Marcus Aurelius. Both authors provide detailed accounts of the disastrous impact of plagues on the social, economic, and political structures place during the years after the plague had passed.

[6] There is a huge and growing research literature on autocracy and tribal conflict. Pulling from my bookshelf, I would first recommend the classics, Arendt’s The Origins of Totalitarianism (1948) and Popper’s The Open Society and its Enemies (1945), and E.O. Wilson’s The Social Conquest of Earth (2012). For more recent works I would recommend Our Tribal Future (Samson), Tribe (Junger, 2016), Twilight of Democracy (Applebaum, 2020), The Monarchy of Fear (Nussbaum, 2018), Culture of Conspiracy (Barkun, 2013), The Righteous Mind (Haidt, 2012), and How Civil Wars Start (Walter, 2022).

The views and opinions expressed in this article are those of Dr. John Rutledge. Assumptions made in the analysis are not reflective of the position of any entity other than Dr. Rutledge’s. The information contained in this document does not constitute a solicitation, offer or recommendation to purchase or sell any particular security or investment product, or to engage in any particular strategy or in any transaction. You should not rely on any information contained herein in making a decision with respect to an investment. You should not construe the contents of this document as legal, business or tax advice and should consult with your own attorney, business advisor and tax advisor as to the legal, business, tax and related matters related hereto.