From the June 2007 issue of Wealth Manager Web • Subscribe!

June 1, 2007

One Size Fits All

As benchmarks go, it's hard to beat the consumer price index for real-world impact. CPI's fingerprints show up on bond prices, cost-of-living increases for Social Security payments and negotiations for certain wage contracts. Of course, the widely followed index also casts a long shadow on Wall Street's perception of price trends in general and inflation in particular.

The CPI, in short, packs a punch. But while no one disputes its entrenched status, there is a lack of absolute consensus when it comes to the index's reliability. Indeed, there's a vigorous discussion in some circles about whether CPI is an accurate measure of inflation.

Given its reach into people's wallets, the stakes in the debate are more than academic. Assume for a moment that the measure is flawed by more than a little by understating inflation, as some critics charge. If so, investors hedging inflation with CPI-indexed Treasuries (and some inflation-linked munis and corporates) are exposed to more risk than is apparent. That may not seem like a big danger these days, considering the reportedly low level of inflation, as per CPI, of course. But if inflationary momentum rises in the future, so, too, will the risk of relying on a flawed benchmark.

Unfortunately, hedging inflation with strategies that sidestep CPI-linked instruments isn't always practical for individual investors. Commodities, for instance, are said to be an alternative defense against inflation. That's debatable as well, but even if it's true, there's a catch. Commodities can and do move independently of CPI at times. Owning raw materials (and their proxies) means holding an inflation hedge that may not seem to be working at times, relative to the CPI. The Dow Jones-AIG Commodity Index, the basis for several mutual funds and exchange-listed securities, has suffered fairly lengthy stretches of losses in the past while CPI continued to rise. Commodities may be inflation sensitive, but the asset class is subject to speculative forces, which may or may not boost its inflation-fighting credentials in the short run.

So while some may question CPI's merit as an inflation gauge, most investors are stuck with it. Until and if there's a better alternative for non-institutional investors, CPI-linked TIPS remain the only game in town for directly immunizing a portfolio against inflation.

That's just fine for most investors, or so a casual observer might conclude based on the market's embrace of Treasury Inflation Protected Securities whose principal is directly tied to CPI. Critics can rail about CPI's flaws, but there's scant evidence that the complaints are taking a toll.

Since the market's launch in 1997, TIPS' outstanding value has grown to $411 billion, as of 2006's close, according to the Treasury Department. That's still a fraction of the conventional Treasury market, but the 10-year-old TIPS market has been growing quickly. The outstanding dollar value of inflation-indexed Treasuries nearly doubled over the previous three years, for instance. Meanwhile, investors can choose from 35 mutual funds and an ETF that target inflation-protected bonds, according to Morningstar Principia.

Compelling or not, the CPI is the standard for general price trends. But do investors really understand the index, including how it is designed and the resulting strengths and weaknesses?

Like any gauge that claims to quantify a complex and nuanced economic phenomenon, the task of measuring inflation involves a fair amount of subjectivity. Consider the evolving mix of factors that collectively determine CPI. There are eight major component groups in the index, tracking prices across a wide variety of products and services. In addition, the weightings of those eight groups continually change, as per the U.S. Bureau of Labor Statistics, which sees fit to adjust the design from time to time.

Constancy, in other words, is not part of CPI's design. At the close of 2006, housing had the biggest weight of the index's eight major groups at nearly 43 percent, up sharply from the end of 1997, as the table on the next page shows. At the opposite extreme was apparel, whose influence on CPI fell to 3.7 percent at last year's close, down from a weight of more than 16 percent in 1998.

The underlying methodology that defines CPI is also a moving target. In fact, debates about formulas break out from time to time, including one in 2004 when Bill Gross, manager of Pimco Total Return--the world's largest bond fund--wrote that CPI was a "con job." In his monthly letter to clients, Gross charged that CPI understates inflation by 100 basis points. The use of what's known as hedonic adjustments is the culprit, he counseled. That's a statistical treatment that factors qualitative changes into prices. As Gross sniffed, "The government says that if the quality of a product got better over the last 12 months, that it didn't really go up in price and, in fact it may have actually gone down!"

A parallel dispute has arisen in recent years over the details for measuring real estate prices in the CPI. In the 1990s, CPI's design was altered so that housing costs were redefined as rental prices. The current formula incorporates the so-called owners equivalent rent index, which is calculated from homeowners' reports on what they can charge for rent. The formula has been criticized because it soft-pedaled the recent boom in actual prices paid for homes. The bull market in real estate over the past several years wasn't captured in the CPI, critics say, leading to another round of complaints that the government is minimizing the true extent of inflation's pace.

"The current CPI understates inflation as the average person would look at it," charges John Williams, an economics consultant who also edits the Web-based newsletter ShadowStats.com, which analyzes data published by the government. By his reckoning, CPI's official rise of 2.4 percent for the year through this past February was really over 5 percent--if the index was calculated under the old, pre-1990s revision. "As a result, the cost-of-living adjustments are shy," says Williams. "TIPS don't give you an adequate return on your money if you're looking to at least keep your capital base neutral in terms of being adjusted for inflation, or even making a little money on it."

Williams may not represent mainstream thinking, but he has some support in concept--if not in detail--from some surprising corners. The Federal Reserve Bank of Cleveland publishes an alternative measure of general inflation that's been running well above CPI of late, although not as high as Williams' estimate. For the year through February, for instance, the bank's median CPI rose 3.6 percent vs. 2.4 percent for the standard CPI.

Nonetheless, the financial establishment and most dismal scientists generally accept CPI at face value. The CPI "pretty much gets it right," says Jared Bernstein, an economist with the Economic Policy Institute in Washington, D.C. There are a lot of arcane discussions about its underlying methodology, but all such measures are educated guesses at best, he counsels.

Lakshman Acuthan of Economic Cyclical Research Institute, an economics consultancy in New York, also says that CPI is fine as far as it goes. But it's hardly perfect, he adds. In fact, most if not all of the government's measures are informed estimates, he notes. As for the CPI, "In theory it should measure the change of a basket of goods that the average person would consume. It probably doesn't do that perfectly."

The CPI's subjectivity should be recognized, but it's not fatal, Acuthan explains. In fact, CPI's primary value (at least from an inflation-forecasting perspective) flows from changes in the index's broad trend, which offers clues about the future path of prices. When the general direction of the CPI reverses, that may be a crucial signal about what's coming. Arguing whether the index is rising by 2 percent or 3 percent is trivial by comparison, he suggests.

Precision does indeed seem to be one of CPI's lesser attributes. The more people you talk to about the index, the wider the viewpoints. Lee Hoskins also says CPI is subjective, but the former Cleveland Fed president tells Wealth Manager that he's convinced the index overstates inflation by as much as 1 percent. Inflation, in other words, is lower than the government tells us. "It's not a perfect measure, but it's the one that's most recognized, and it seems to me to be a perfectly acceptable [inflation] target," says Hoskins, a senior fellow at the Pacific Research Institute and an advocate for a monetary policy that aims to keep CPI to a zero-percent inflation target over time.

CPI, for all its influence on real dollars, is but one gauge in a sea of alternatives. Perhaps it's telling that the Federal Reserve reportedly favors personal consumption expenditures (dispensed monthly by the U.S. Bureau of Economic Analysis) as its preferred measure of inflation. The reason is the design. PCE tracks consumer decisions, and so inflation derived from this index reflects the human factor. CPI, by contrast, reflects prices drawn from a fixed basket of goods and services.

"The CPI measure is based on a constant basket of goods and services whereas the PCE is based on actual consumer expenditures," explains Tom Higgins, chief economist of Payden & Rygel, a Los Angeles-based money manager. "The reason economists prefer the PCE is because it's a moving basket and it's a more accurate reflection of people's experience with inflation." Consumers, in other words, don't limit purchases to a fixed basket of goods. If steak becomes expensive, shoppers may switch to hamburger. In fact, trying to capture the human factor in inflation measures is the rationale for CPI's hedonic tweaks, albeit tweaks that Gross criticized.

No matter which inflation measure you prefer, the broadly designed ones all suffer from what might be called a macro bias. An inflationary climate for one investor may be disinflationary--or even deflationary--for another.

A 65-year-old woman of modest means with a recurring out-of-pocket prescription medicine bill is likely to have a different view of inflation than a single, healthy, 25-year-old with a budding white-collar career. Indeed, medical care inflation rose by 4.3 percent in the 12 months through February, or nearly twice as much as inflation generally, according to CPI.

Like the proverbial blind men describing an elephant, everyone's inflation is different. True, but it doesn't change the fact that all roads for hedging inflation lead back to the same index. One size fits all, like it or not.

JAMES PICERNO (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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