Questioning "Core Inflation"

Mark Gongloff and Scott Patterson in the Wall Street Journal proclaim, "Many economists and Federal Reserve officials like to dismiss energy and food prices when reading inflation statistics because the two sectors are volatile. But it is time to dismiss that practice." The inflation you and I suffer from when we pay higher prices is called "headline inflation." Economists hope to find the underlying trend by eliminating the prices that jump around the most. To achieve that goal they subtract food prices and energy prices from the consumer price index and another more comprehensive index called the personal consumption price deflator. When inflation is measured by these bowdlerized indices, it is labeled "core inflation."

The problem with core inflation is that it excludes prices that are sometimes leading indicators of future inflation.

Moral Hazard

Moral hazard is the prospect that a party entering a contract becomes insulated from a risk and that insulation causes him or her to behave differently to the other party's peril. The contract changes incentives and the changed incentives causes one party to behave differently. A few examples will clarify this.

If you rent a car or your residence to someone, you, as the owner, run the risk that your renter will not treat it the way you would treat your own property. By entering into the rental agreement, you, the lessor, incur moral hazard. If you doubt moral hazard exists in rental contracts, ask yourself why landlords require deposits, and why you as a used car buyer worry more about a rental car than one you buy from the sole owner.

Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore acts less carefully than he or it otherwise would. This leaves another party bearing some responsibility for the consequences of those actions.

Insurance is rife with moral hazard: Why? An insured party's behavior will be riskier than it would have been without the insurance.

In life insurance, moral hazard can arise when the insured can self select. A life insurance company bases its rates on the actuary tables for the average person. If I know everyone in my family has died young, it make sense for me to buy more insurance than normal. This adverse selection will cause the life insurance company to undercharge me for the true risk of my living less the actuarial tables predict.

In banking, deposit insurance creates moral hazard. Consider a hypothetical bank we could call Loan Prone Savings and Loan. The FDIC insures Loan Prone's deposits. The bank gets in trouble. Loan Prone's loans are not sufficient to pay off its depositors. Perhaps its books do not yet show its true condition. They comply with banking regulations, but they do not show the true value of the loans. What can Loan Prone's managers do?

They note that if the bank can get more funds (by taking in more deposits), it could make some new loans. So Loan Prone offers an above market interest rate to attract more deposits. There is no risk for the depositors, their deposits are insured. Note: without deposit insurance, depositors would have a strong incentive to investigate a bank's soundness. With deposit insurance, that incentive is gone.

The bank does not care if its losses grow, Lone Prone is already "in the soup." Maybe it can recover enough from the new loans to get back in the black. Thus Loan Prone hopes that it can find some profitable investments to recoup its loses. It goes for higher interest, but riskier loans. It is gambling to get back into the game. The depositors do not care: the FDIC is going to get stuck paying off them off even if the loans go sour.

Neither the the bank nor the depositors are behaving the way they would in the absence of deposit insurance. That is the essence of moral hazard.

Economic Terms and Concepts

The Present Value of a future cash flow discounted at X% is the amount of money you would need to invest today earning interest compounded annually at X% to accumulate that future amount. It answers the question "How much do I have to invest now to end up with that future sum if I earn the discount rate?"

A bond's Yield to Maturity is the one discount rate that equates the present value of the cash flows (interest payments and principal) to the price.

A security's Current Yield is its annual income divided by its current price. For a bond it is the coupon interest divided by the price. For a share of common stock, it is the annualized dividend divided by the price.