CPI understates inflation

When you hear about inflation on TV, don’t you often wonder why the official number seems lower than inflation feels to you when you go shopping? It’s an open secret in Washington, but the Consumer Price Index (CPI), the common measure of inflation, understates inflation. How this occurred is not entirely clear, although many speculate. However, what is clear is that it means you are being deceived about the state of the economy.

History of CPI
The CPI is a statistic issued monthly by the Bureau of Labor Statistics, which is part of the U.S. federal government. There are CPI measurements all the way back to 1913, before World War I. I have spreadsheets with a precursor to the CPI called the General Price index going all the way back to the 1860s.

The CPI uses a ‘basket of goods and services,’ weighting them according to their relative importance in the economy, in order to obtain an overall index price level. This basket includes things like cars, TVs, cheese, beef, chicken, gasoline and so forth. More information on the history and construction of the CPI is available at Wikipedia.

The CPI is an important measure because it allows businesses and consumers to understand the real purchasing power of the money they earn. $100 is worth less when inflation is 8% than when it is 4%. But, the level of inflation also allows us to get a sense of how well the economy is doing. If the economy grows 7% per annum, an inflation rate of 4% means the economy grew 3% in real terms, while an inflation rate of 8% means the economy actually contracted.

Obviously, the CPI and other similar measures of inflation are important measuring sticks for all kinds of economic decisions we make. Therefore, the integrity of these numbers is paramount. Yet, the CPI has been tweaked and changed consistently for some time now. As you would imagine, most of these changes serve to reduce the official level of inflation, making our economic growth look better and earnings look more valuable. While it can’t be assumed this is being done for nefarious reasons, the cumulative effect of all these changes clearly gives a distorted view of the economy to the general public, overstates growth, understates earnings, and shortchanges those whose earnings are tied to the rate of inflation like Social Security recipients.

Substitution effect
The changes in inflation measurement began in earnest during the Carter administration as inflation began to spiral out of control. In the 1990s, a (potentially false) debate began about whether the CPI actually overstated inflation. The argument was as follows: if the price of beef increases, people will switch to buying chicken in what is known as the substitution effect. In essence, the relative weighting of the basket of goods changes as the price level for individual basket items increases.

The Boskin Commission was formed in order to investigate these issues. Wikipedia describes the conclusions resulting from the Boskin Commission:

In 1995, the Senate Finance Committee, appointed a commission to study CPI’s ability to estimate inflation. The CPI commission found in their study that the index overestimates the cost of living by a value between 0.8 to 1.6 percentage points. Because the CPI is so widely used as an inflation adjustment, the fact that it is overestimated, even by such a small percentage, has several consequences.

The fact that CPI overestimates inflation suggests that claims that real wages have fallen over time are possibly unfounded. Additionally, it would suggest that real GDP growth, which is calculated using the CPI, is severely underestimated. An overestimation of only a few percentage points compounds over time. In the 1970s and 80s the Federal Government began indexing several transfers and taxes including Social Security (see above Uses of the CPI). The overestimation of CPI would imply that the increases in these taxes and transfers have been greater than necessary, meaning the government and taxpayers have over paid for them.

The Commission concluded that more than half of the overestimation was due to slow adjustments in the index to new products or changes in product quality. Because the index weights are only adjusted once every ten years, the CPI does not account for new technologies that are adapted by consumers quickly. For example, by 1996 there were over 47 million cellular phone users in the United States, but the weights for the CPI did not account for this new product until 1998. This new product lowered costs of communication when away from the home. The commission recommended that the BLS update weights more frequently than ten years to prevent new products from causing upward bias in the index.

Additional upward biases come from several sources. Fixed weights to do not accommodate consumer substitutions among commodities, such as buying more chicken when the price of beef increases. Because the CPI assumes that people continue to buy beef, it would increase even if people are buying chicken instead. The Commission also found that 99% of all data were collected during the week, although an increasing amount of purchases happen during the weekend. Additional bias stems from changes in retailing that is unaccounted in the CPI.

The claims of the Boskin commission were dubious.* However, it was decided to re-weight the basket of goods as prices rose on individual goods in order to reflect the substitution effect. As a result, the CPI does not measure true inflation through a static basket of goods, but an ever-changing basket based on consumers substituting out basket items as they rise in price. As an example, it’s like re-weighting the index to reflect the fact that more people are buying beer because wine has become too expensive. This serves to understate the true cost of the desired basket of goods in favor of a less expensive actual basket.

Hedonics
The next major step taken in the 1990s was around the issue of Hedonics. As technology advances, items like Computers and Televisions become more sophisticated. This increase in sophistication that consumers enjoy is not taken into effect by the actual price of the goods. Therefore, the CPI must be adjusted downward to capture the hidden price reduction from ‘hedonic improvement’ or so the theory goes. As an example, a Computer in the year 2008 is much more sophisticated than one from the year 2002. Therefore the theoretical price of the computer in 2008 must be adjusted upward to reflect this. Since the actual price is less than this theoretical price, the difference serves to reduce the measurement of inflation.

If this sounds like nonsense to you, I can’t argue with you.**

Core Inflation
The last ridiculous inflation calculation is the Core CPI. This measures the rate of inflation minus food and energy. Food and energy are two of the largest components in the basket of goods we buy. But they are excluded in order to see the underlying ‘core’ inflationary trend. The theory goes like this: Because food and energy prices are volatile in ways that have nothing to do with the overall state of the economy and the inflationary pressures resulting from the business cycle, to predict the future path of inflation, they must be excluded.

The problem with the Core CPI is that it has been woefully inadequate in signaling the danger associated with stubbornly high food and energy price inflation. If the cost of milk, rice, OJ, oil, or you name it keeps rising for months or years, the Core CPI becomes meaningless. That is what has happened over the past few years.

Conclusion
All of which is to say: We have a very distorted view of inflation. As a result, we have a very distorted view of the real growth rate of the economy. If the CPI were measured today as it was in the 1970s, we would have seen a much deeper recession in 2001-2002 and we would see that we were clearly in recession today. Like it or not, the present meausure of inflation has deceived the general public into believing the economy has been more robust over the past 15-odd years than it actually was.

*The website Shadow Government Statistics does an excellent job of re-working Government statistics to reflect the CPI before the Boskin commission and before other changes in the index.

**Hedonic adjustments only serve to lower inflation by artificially lowering the cost of goods. But, what about service? Why us there not an increase in the implicit cost of services using Hedonics. After all, service quality has declined as most things have become automated. Calling customer service in today’s world is significantly ‘more expensive’ from a hedonic perspective than it was in the 1980s. This example demonstrates how these adjustments cumulatively skew CPI downward.