A new way of looking at inflation...
It's time that the Federal Reserve and policy makers there recognize the antiquated nature of our current inflation metrics. All of our metrics are used heavily based on consumption and they tend to ignore things that are considered "Investments". There was a large (appropriate) push in the 90's to change the metrics because the perception was that they overstated inflation. At the time, the large technical and technological expansion in our economy wasn't properly being factored into the equations. The popular example that economists gave was Anti-Lock Brakes on cars. The ubiquity of these has clearly made driving safer, and yet we measure that as "inflation" when the car prices tick up to accommodate it.
We have an opposite problem now however. Our metrics for housing are terrible. Let's look at the basic numbers
In 1980, the average house was approximately 1700 sqft worth $30,000. The typical buyer put 20% ($6,000) down and took out a 25yr mortgage. Payments were $185 per month based on the prevailing 8% rate.
In 2005, the average house was approximately 2000 sqft worth $200,000. The typical buyer put 5% ($10,000) down and took out a 30yr mortgage. Annual payments were $1,139 based on the prevailing 6% rate.
The current inflation model looks at those and calculates the inflation rate based on the $185 vs. the $1,139 (approximately 7.5% per year)...
However, a good inflation model would look at that and realize that the true cost of the house has increased from $17.6/sqft to $100/sqft and calculate based on that (which works out to be 7.1% per year.
This is the critical distinction that has escaped the fed in recent years. Asset price run-ups are just another form of inflation. The Fed has worked hard to control core inflation and, as a result, core inflation stays low. But the free-market will always find an outlet when it needs to adjust itself. In the case of our economy, it found real estate. My worry now is that all the people that are happy about fed rates cuts (i.e. Wall Street) are reading the wrong signs. In this case, the market (and here I'm talking in the group sense of the word rather than any one individual or set of individuals) isn't pricing in better economic times... They're pricing in inflation. When inflation hits, stock prices have to rise as well.
The fed has cut rates to a level that we haven't seen since... well, the last time the Fed slashed rates... And we know how that ended. Enough is enough. Take inflation seriously. Recognize that the rate we're at now is already accommodative. Let the market work its way out and let some companies get pummeled. If some big banks (I'm looking at you Bear Stearns) didn't properly anticipate liquidity needs then they should fail. We have a much more robust and trusted banking system then we did prior to the great depression. Let's put some faith in that for once.
On a side note: I keep reading that the Fed "bailed-out" JPM Chase / Bear Stearns to make that deal happen. But I've seen no mention of what the actual "bail-out" was. Has anyone read anything that actually articulated this or are they just assuming that Paulson and Bernanke making phone calls constitutes a bail out?
