Will the Real Rate of Inflation Please Stand Up?

Since the Great Recession of 2008-09, central banks around the world have been haunted by the specter of deflation. That is, a broad decline in asset values and consumer prices. They have resorted to extraordinary measures, particularly “quantitative easing,” in order to boost inflation. Yet by all accounts, inflation has remained stubbornly low, despite the creation of nearly $4 trillion of new cash by the US Federal Reserve alone.

The Consumer Price Index (CPI) is one of the most closely watched economic statistics today. Not only does it provide insight into the cost of living, but also into future Federal Reserve policy. This is a crucial dilemma the Fed faces right now, as they are torn between the forces of rising commodity and raw materials prices, rising asset prices and a housing boom, and the need to shrink their balance sheet via “quantitative tightening.” Misjudged policy could result in a recession, or higher inflation, or both at the same time, as we experienced in the 1970s. An accurate assessment begs the question of whether the inflation yardstick itself is accurate.

The importance of an accurate price inflation gauge cannot be overstated. Many compensation benefits are tied to the CPI, and many economic statistics are expressed in “real” (i.e. with inflation stripped out) terms in order to determine how the underlying economy is performing. The U.S. government uses it to adjust payments of certain escalating contracts, Social Security payments, taxes and a number of other expenditures. Corporations use the CPI to also adjust payments on inflation-tied contracts, as a gauge for the condition of the economy and for capital budgeting decisions. Individuals may also use the CPI for a number of different purposes; landlords, for example, use inflation to adjust rents and individual investors use inflation to assist in making investment decisions. Billions of dollars in transactions hinge on tenths of a percentage point change in this key economic indicator.

The aim of the index is to be a cost-of-living index. According to the BLS, both the CPI and a true cost-of-living index would reflect price changes in the prices of goods and services, but the Bureau admits that the CPI will unlikely correspond to any individual’s experience with price change, because each of us consumes a unique basket of goods and services. The elderly, for instance, spend a higher proportion of their incomes on health care than the population at large. Thus, the effects of a rise in health costs are felt more keenly by this group, prompting them to wonder how anyone can consider inflation “under control.”

While there is no arguing about the comprehensiveness of the CPI, what it omits is as important as what it includes. For instance, the cost of employer-paid healthcare insurance is not counted. This rapidly rising expense would obviously bias the CPI upward. In fact, costs here are rising so much that more employers are putting part of the healthcare burden on employees’ shoulders, as businesses cannot afford the full cost. So perhaps this increasing out-of-pocket consumer cost will soon find its way into the CPI numbers. This is a huge omission when trying to reflect the true cost of living in the United States.

In order to accurately reflect consumer reality, several adjustments to the CPI were introduced in the 1990s. The first concerns substitution. For instance, if the price of a McDonald’s Big Mac rises relative to the price of Chicken McNuggets, there will be some substitution of cheaper Chicken McNuggets for dearer Big Macs. The theory is that the rational consumer will buy the cheaper good, keeping her personal CPI lower than it would have been without substitution. But here’s the flaw to this technique. If you substitute McNuggets for Big Macs because they’re cheaper, then switch back to Big Macs because the price of McNuggets rise (eliminating the relative price increase between the two), the overall round trip resulted in no overall substitution and no relative price change, but has reduced the stated CPI.

Another adjustment came with the introduction of the “core” CPI, which excludes food and energy costs due to their volatile nature. Since these two categories account for 15% and 9% of the CPI, respectively, the “core” CPI eliminates 24% of what we spend our money on. Of course, the fallacy is that we can somehow eliminate eating, driving, and heating our homes from our lives. This most unrealistic calculation is nevertheless trumpeted monthly as a meaningful reflection of life in the U.S. (to Wall Street’s predictable cheerleading). A low core CPI allows economists to pretend that American productivity is the best in the world, and that consumers will continue to shop ‘til they drop since food and energy costs are trivial.

Perhaps the most controversial adjustment concerns quality improvements of goods and (harder to measure) services. Known among econo-geeks as “hedonic” adjustment, it tries to combine improvements in quality with price changes. Basically, the BLS uses hedonic adjustment to try and quantify gains of quality in a particular good in order to offset gains in price. For instance, if a computer operated at 50 MB (megabytes) of memory a year ago, and 1000 MB today, the BLS would claim the price of the computer today reflects much higher quality, so the price must be adjusted downward dramatically to account for quality. The effect is to reduce the CPI even if the good cost more in dollars.

Very little mention is made in the available research about declines in quality, which should raise the CPI numbers using the same logic. One only has to leaf through the latest issue of Consumer Reports to find examples of deteriorating quality in goods, and also services such as lousy cell phone service providers or more restrictive health insurance plans. Also omitted from hedonic adjustment are potentially hurtful items such as lead-tainted toys from China.

Hedonic adjustment got its big push beginning in 1998, when adopted for computer prices. Since then, the BLS has expanded the concept to include audio/video equipment, washers/dryers, and, unbelievably, college textbooks. Today about 46% of the weight of the U.S. CPI comes from products subject to hedonic adjustments. PIMCO, the largest U.S. fixed-income manager, estimates that without hedonic adjustments, the Personal Consumption Expenditures (PCE: similar to the CPI) would have been 0.5% to 1.1% higher each year since 1987. Their conclusion is that since inflation was higher than reported, “real” economic growth must have been lower as well.

While theoretically attractive, hedonic adjustment misses a key point. In all likelihood the good purchased was for the same or slightly higher price, regardless of quality (have Lexus cars dropped in price over the last 5 years?) Consider the following example. Say the only product that Americans purchase are M&M candies—100 M&Ms in a bag that costs $1.00. Each person is limited to one bag. Through the miracle of productivity, a way is found to fill each bag with 110 M&Ms that is now priced at $1.10. Hedonic adjustment would say that the bag really only costs $1.00 and that the CPI has not increased, since each M&M still costs a penny each. But the cost of the bag of M&Ms has gone up. And since each person must buy a bag, instead of an individual M&M, their cost of living has gone up by 10%. They must fork over an extra dime even though they’re getting more for their money. Now turn the M&Ms into computers and cars, and the point becomes clear. We can’t buy individual parts of a new car; we have to buy the whole car, complete with quality improvements. And the whole package costs more, improved or not.

While hedonic adjustment may accurately reflect productivity increases, they don’t accurately reflect America’s cost to live. These adjustments accrue to businesses (which in turn don’t provide adequate raises) and the federal government (which in turn under-compensates Social Security recipients).

Finally, the change in various calculation methods has biased the CPI to the downside over the decades. The web site ShadowStats (www.ShadowStats.com) provides a valuable perspective on this change, as they provide display CPI calculations for the 1990 and 1980-based methodologies.

Based on 1990 calculations, today’s CPI would be about 6%, while the 1980 calculation would report current CPI at over 10%! This underscores how much the official statistics have changed over the years. Certainly it has been in the government’s interest over the past 30 years to report inflation that is low, given that so many benefits and contracts are indexed to inflation.

Our belief is that the CPI inaccurately calculates the true cost of living, and is partly to blame for the inconsistencies we see between reported high GDP growth, anemic real wage growth, and the value dislocations we are witnessing in the stock, bond, and real estate markets. If we are to avoid distorting our economic progress and prevent major policy mistakes by the central bank, Democratic and Republican policymakers alike should seek a more realistic measure of price inflation.

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