• December 5, 2022

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Economists see a still high CPI inflation coming in the October U.S. Bureau of Labor report (Thursday, Nov. 10 at 8:30 AM). Per Econoday consensus estimates are 8% for CPI All-Items (vs 8.2% for September) and 6.6% for CPI Less-Food & Energy (the same as September).

So, where’s the surprise?

In three places: The adjustment, the calculation, and the interpretation.

First, the adjustment – Economists smooth out monthly volatility by seasonally adjusting each month for common calendar-based data shifts. For September, the seasonal adjustments were significant and mostly in the same direction – increased price inflation. The monthly rate for CPI All Items doubled from 0.2% to 0.4%, and for CPI Less-Food & Energy, a 50% increase from 0.4% to 0.6%.

What was the reaction to those seasonal adjustments during such an extraordinary time? Nothing. No discussion or even mention was made. The importance in noting the adjustments is that they were made while other forces were at work that could alter normal seasonal patterns. Also, the adjustments were large increases, meaning without them, the general view of inflation would likely have been more positive.

Because annual numbers are the preferred figures to examine, let’s annualize those monthly numbers: CPI All-Items was seasonally adjusted up from about 2-1/2% to about 5%. CPI Less-Food & Energy was up from about 5% to about 7-1/4%.

So, why are those CPI All-Items rates so far below the reported 8.2% rate? The chosen calculation is the answer.

Second, the calculation – Because even the seasonally-adjusted monthly rates are variable, economists prefer to look at the trailing 12-month inflation rate. However, it’s not a smoothing-out process. Rather it’s a simplifying method of breaking a change into 12 bits by adding a month to, and subtracting a month from, a 12-month string.

An analogy would be tracking your speed (miles per hour) for a multi-hour trip by measuring the distance travelled every five minutes, then adding twelve increments together to get the hourly figure. Following, after each 5-minute period, you add the new 5-minute distance and subtract the oldest one to maintain the 60-minute total. Voila! Your new MPH. Well, obviously, not. Eleven of those periods remain, so each 5-minute change only affects one-twelfth of the 60-minute measurement. So, too, for any trailing 12-month or 4-quarter or 5-year measure that gets updated with a partial change. It looks smoothed, but its just a s-l-o-w adjustment.

Third, the interpretation – If a steady trend is in place, then the latest monthly number should be in line. But both CPI measures have trends the Federal Reserve is attempting to push down. Therefore, the trailing 12-month rate hides the desired dynamics at work. Also, “12” is an irrelevant number of months. What matters is the monthly behavior of the CPI rates from the time the undesirable increases started.

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Two graphs show the reality

The first graph shows the two CPI indexes tracking steadily through 2019. After slowing through the Covid months, they returned to the trend line level in mid-2021. Then the higher rate moves began. Note that during the last three months, the CPI All-Items growth rate slowed. (By using a logarithmic scale, a constant growth rate shows up as a straight line.)

The second graph shows the annualized monthly rates for the 15-month period from mid-2021. Note the two circled areas. They are the last three months added and subtracted for the trailing 12-month calculation. For CPI All-Items, the subtractions were from a higher-rate periods and were replaced by lower inflation readings (causing the line shift above). For CPI Less-Food & Energy, it was the opposite, thereby maintaining its rising 12-month inflation rates. (These opposite changes are why the media reports shifted focus from CPI All-Items to CPI Less-Food & Energy.)

Now, look at the months coming, starting this Thursday. Much higher rate months enter the replacement queue. If higher interest rates have had an effect, we could see the first, real slowdowns in both CPI measures. This is why there is a decent chance those October economist expectations above could be too high. Moreover, because October is only the beginning of a long run of higher rate replacement months, there’s a good possibility (once again, if…) that both the 12-month and the index lines will show continuing positive improvements. And that would be a surprisingly positive stock and bond market development.

The bottom line – Sometimes, a polished-up statistic doesn’t cut it

When times are topsy-turvy or conditions are abnormal, drop the focus on seasonally-adjusted, smoothed-out calculations. Instead, grab the nominal (AKA actual) data and analyze. It’s at such times that profitable investments can be made or avoided using subjective reasoning. And this looks to be one of those times.

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