Have you noticed something?

Check out this graph.

Inflation has been redefined in the business press as "core inflation". That is, energy inflation doesn't count any more for public discussion. This is an interesting caveat. As anyone who follows bls statistics knows "core inflation" is an inflation number without energy, the argument being that this "strips out" the "volatile" food and energy sector. However, this is doubly dishonest. First, food and energy have been running ahead of the rest of inflation for some time now, second there are simple financial formulas to get rid of what is called "marginal behavior". If people want to know what the "non-volatile" number for inflation is, then the simplest tool is to take a moving average, not to remove particular components. If one wants a more sophisticated tool, one can take kendall's tau of the inflation series over time – which is a statistical tool to find the correlation between two data sets removing the differences in volatility from both. Finally one could apply GARCH – an algorithm for analyzing numbers that are not only volatile, but have changing rates of volatility.

The above graph is the ratio between CPI-U and its "core" number, and CPI-W and its core number. If removing "Core" inflation was simply removing a series that was simply stripping out volatility, one would see the same curve, – as it was in the 1990's – then you would see rises and falls above and below a mean value.

In 1983 the asset inflation in housing was removed from CPI. This has the effect of allowing booms to go on longer, because it eliminates the "housing bubble" effect, and thus allows the Fed to keep interest rates lower long, and it means that recessions will be slower to recover from, because when housing bubbles "pop" that doesn't show up as a drop in inflation. It has also masked the massive housing bubble that we have now. This is important because money is created when banks lend, they can lend based on assets, and housing asset prices are counted there. This may sound simple, but it is John Kenneth Galbraith who noted that "the process by which banks create money is so simple, the mind is repelled."

The net effect of this is that the money supply is based on asset inflation, but the interest rate is not. This has created a perverse incentive for administrations and the Federal Reserve – allow housing inflation. Since housing does not generate export, but, on the contrary creates import demand for energy and consumer goods such as home electronics – the net effect of this is to increase the money supply, which drives general inflation, and to increase the trade deficit.

There have been calls for consumption taxes, but this is backwards, the better mechanism – the free market one – is simple to make it so that the Fed is no longer allowing asset inflation in the first place. Otherwise what one is really doing is using home owner equity as a means of creating money to speculate with.

This may sound complex, but the effect is visible: an ever growing trade deficit, as more and more effort is poured into housing, which runs well ahead of inflation, and that housing creates demand for imports, both by creating the desire, and providing a "wealth effect" to fund it with. That's demand in economics – desire plus money.

The redefinition allowed inflation numbers to be reduced – very important both for consumer and business confidence, and because the government is "on the hook" for inflation in the form of Social Security – lower inflation means smaller Cost of Living Adjustments to Social Security. This means smaller social security checks.

However, even this adjustment is no longer enough – instead, inflation is, effectively, being redefined again to exclude energy costs. Energy inflation no longer "counts" for considering economic condition. This means there is a direct transfer of real wealth from everyone else, to energy producers. Don't blame Exxon for high energy prices, blame policy which now has the implicit objective of transferring money to energy producers, without any requirement that they reduce inflation.

There is a good reason for this. Energy producing nations provide much of the liquidity to cover our trade deficit. They will want an assurance that we are not going to tax them in order to fund our deficits, or indeed anything else. This indicates that a fundamental mechanism of neo-liberalism is dead. Namely, that developed nations will not impose self-discipline to prevent energy prices from going up.

To explain, between 1982 and 1998 an important pillar of policy in the G-8 was not to import more energy from OPEC and other energy producing nations than they exported. The idea was that this would squeeze energy exporters, and prevent them from gaining too much control over the world financial system. For what ever the problems with this system, it worked – energy prices marched downward, and with them commodity prices. While the gold bugs are screaming about it now, the current trend of energy getting more expensive than other goods began with the response to the Asian financial crisis, and somewhere in 2003 the decision was made, or not made, to restrain federal spending in the US, or use monetary or tax policy, to bring the movement of energy inflation back into line. This has become general commodity inflation – gold, steel, copper and so on.

This means that this new "redefinition" of inflation is directed at keeping the holders of US instruments, namely energy exporters who don't have stake holders, and so can invest abroad, not at any underlying fundamental irrelevancy of energy to general inflation. Or as Barry Ritholtz puts it "Inflation is fine so long as you don't move or eat."

In short, since 1983 we have been pretending that housing inflation doesn't count, and now even that isn't enough, and we are having to pretend that energy inflation doesn't count either. The first allows loose money, but creates excessive energy demand. This worked so long as policy kept inflation prices in line. Now policy has let the energy genie out of the bottle, and is trying to hide behind a talking point that is rotten to the core.

The first redefinition produces chronic current account deficits, because it shifts efforts from production, to consumption. It also creates a pool of easy money looking for returns. The second shifts real wealth from the US and developed nations, to energy producers and resource producers. This produces wealth in poor countries - among those who control the energy supplies. This is why Putin of Russia is becoming more and more aggressive, this is why energy socialism is sweeping Latin America - because there is a fight to use that energy money to do more than buy luxuries for the upper classes. In places like Dubai, there is the reverse effect - conspicuous super-consumption by the small elite that receives all of the oil revenues.

This is creating a more and more unstable situation, as the financial power in the world is flowing to groups that do not have an interest in the political or economic stability of the developed world. Far from being a "clash of civilizations", our present problems are driven largely by a series of attempts to delay dealing with problems.

Perhaps that was the right decision in the early 1980's, as many technologies required to move away from a petroleum driven economy were in their infancy. But in the present, it is a bad decision, because it leads down a road that is more costly than the other choices - the opportunity cost of building mcMansions and inflation wagons, that's SUVs - is very high at this point.

The continual repetition of "core inflation remains tame" is not a good sign, because industrialized nations make "core" items, and import "non-core" items. One man's inflation is another man's pricing power - saying "core inflation remains tame" is another way of saying that manufacturing does not have pricing power globally.

This leads into a discussion of currencies, and why the current currency problem is the result of this basic dynamic of needing to appease bond holders with oil revenues.