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Inflation Numbers Are Worrying
Smart Money
April 30, 2007

THE BUREAU OF LABOR STATISTICS announced Tuesday that core inflation in March rose by only the tiny amount of one-tenth of one percent. When that number was released before markets opened, one could almost hear the sigh of relief all the way from Wall Street to Washington.

Just think: If there's no inflation, then Ben Bernanke will be free to lower interest rates. Then all our worries about the housing bust and the subprime meltdown can just fade away.

Sadly, Tuesday's inflation number for March was nothing more than March madness. The number was completely fake. Inflation is still the clear and present danger that Federal Reserve officials keep saying it is every time any of them speaks to the public.

To see what was wrong with March's inflation number, you have to understand a little bit about how inflation statistics are calculated by the vast bureaucracy within the BLS — a division of the Department of Labor that is living up to its mandate, apparently, by employing as many economists as possible.

According to that sprawling army of men and women in green eyeshades, March's inflation number was kept low by apparel prices dropping 1%, and hotel prices dropping 2.2%.

But in reality, apparel prices rose by 3%. And hotel prices rose by 2.3%. But that's only in reality. In the bureaucrats' minds, their prices fell.

It's all part of an arcane process called "seasonal adjustment."

The idea is that at certain times of the year the prices of certain goods and services can be regularly expected to fluctuate up or down, for reasons that have nothing to do with inflation. So the BLS 'crats "adjust" those fluctuations away, with the idea of leaving us with a clearer view of inflation forces at work.

My colleague David Gitlitz, the chief economist of my firm TrendMacro, asked a BLS staffer about the huge adjustment to March hotel prices — all the way from an actual rise of 2.3% to an "adjusted" drop of 2.2%. The staffer told Gitlitz that BLS makes that adjustment every March, to take account of the temporary spike in hotel prices that always occurs in connection with the NCAA basketball playoffs. He said that around the water-cooler at BLS they call that adjustment "March madness."

That means that for hotel prices to just stay unchanged in March they have to actually rise by 4.5%. This year they didn't. Is that because there was especially little inflation in March? I highly doubt it. Maybe it was the unusually cold weather in the East. Or maybe it's because this year is only the second year in which fans can subscribe to the whole NCAA playoff series on satellite TV, and watch from the comfort of their living rooms.

And how about apparel? To overcome the BLS adjustment, apparel prices have to rise 4% in March just to appear to stay the same. Why? Who knows? Maybe it's the introduction of the new spring lines. But with March's colder weather, maybe those lines didn't look so appealing. And just what does that have to do with inflation? Nothing.

Yet, thanks to these "adjustments" — these essentially spurious flukes in a bureaucratic process — the investing public has been led to believe we have an all-clear signal on inflation.

We don't. If you take away all the seasonal adjustments from March's core inflation, the number wasn't the benign 0.1% that was reported. It was actually a torrid 0.4%. Keep that up for a whole year and you've got a 4.8% inflation rate.

Remember, the Fed's "comfort zone" for inflation has a high-end boundary of 2.5%. The Fed is smart enough to see through the distortions of seasonal adjustments. They know that we're way outside the "comfort zone." The odds of rate cuts here are zero. Inflation is just too much of a threat.

The Cleveland Federal Reserve — one of the district Federal Reserve banks — has its own way of looking at inflation that filters out anomalies like the one I've been discussing here. They call it the "trimmed mean consumer price index." When they say "mean," they mean "average." And when they say "trimmed," they mean that every month they throw out of the calculation whatever elements are the most volatile and out-of-pattern.

In March, the "trimmed mean CPI" was up 0.3%. And that strikes me as a reasonably correct number. It's not as extreme as the seasonally adjusted 0.1%, nor the unadjusted 0.4%.

And 0.3% inflation in a single month, even if it's not as bad as 0.4%, is a lot more than the Fed wants to see.

The Fed knows the truth about inflation, even if the perpetually deluded bond market still doesn't get it. The Fed knows that inflation bottomed in December 2003, and has been in an uptrend ever since. There have been months, or even quarters, in which the rate of inflation has fallen a bit — but it's always been within the context of the overall uptrend.

Think of inflation as a stock price as you look at this chart of core CPI. Wouldn't you call this an uptrend?

With gold, commodities and oil rallying, and with the dollar making new lows daily, inflation isn't breaking this uptrend anytime soon. And the Fed won't be lowering interest rates, either. The next rate move will be up, not down. You don't want to be anywhere near the bond market when that happens.

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at

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