The Truth About Inflation: Prices Don't Deceive, The CPI Does

by: Ben Kramer-Miller

Recently the deceleration of the CPI, as well as the underperformance of assets that generally outperform during periods of inflation (e.g. commodities, foreign stocks and foreign currencies) have led to an onslaught of claims that there is no inflation. Here are some examples of such claims:

These observations, and the conclusion drawn from them that there is no inflation have led to attempts to explain why this is the case despite the fact that the Federal Reserve is purchasing $85 billion worth of bonds every single month. The most popular reason cited is that despite the fact that the money supply is increasing, the velocity of money is declining, as the following chart from the St. Louis Federal Reserve illustrates.

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The velocity of money measures how fast money is changing hands. The conclusion that there is little to no inflation seemingly follows from the idea that even though the Federal Reserve is "printing money" this money is not going out into the economy: it is just sitting on bank balance sheets and not bidding up prices.

Another argument given to justify the "fact" that there is little to no inflation is the decline in the money multiplier, or the ratio of M2 money supply which counts credit and bank deposits, to the monetary base, which is the size of the Federal Reserve's balance sheet. The following chart shows this ratio.

The idea here is that because the demand for credit is so low the money supply is not increasing fast enough to spawn inflation.

While these arguments are put forth to justify the fact that there is little to no inflation, they do not. All they can justify is the fact that the inflation rate is lower than the rate at which the monetary base is growing. The following is a chart of the monetary base in the United States starting from the beginning of the 21st century:

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In January, 2001 the monetary base was at roughly $590 billion, while it is at $3 trillion now. This represents a compounded annual growth rate of roughly 14%. But at this point in time the Federal Reserve is increasing the monetary base at a rate of just under $1 trillion per year, and from a $3 trillion basis this is roughly a 33% increase annually. Thus the justifications given for the presumably low inflation rate can at best explain why the inflation rate is not at least 14%, or 33%.

In this article I present an argument that there is meaningful inflation. I do this by looking at several pieces of price-data, which gives a general overview of prices in the United States. Of course I cannot cover everything, but by looking at a few key pieces of data (as well as some random niche data that would apply to only a few people in the population) I hope to convince the reader that the rate of inflation is significantly higher than the 1.1% rate that comes from the Bureau of Labor Statistics.

If the rate of inflation is much higher than the Consumer Price Index, why is the BLS so inaccurate?

In the next section I address this question by looking at some of the methodological developments utilized by the BLS over the past few decades. While there might be some academic merit to these developments, one has to wonder why it is that these changes have only served to reduce the CPI, which, were it calculated as it was in 1980, would be significantly higher than 1.1%.

One has to wonder if the BLS is motivated to understate the CPI, and in fact it is: I suggest that there are three primary reasons that the BLS would be motivated to understate inflation, although I must be clear that there is no indication that the BLS attempts to intentionally reduce the CPI.

Given this information the reader is asked to decide whether the data points I give, or the CPI best reflect the "true" inflation rate, and I give some investment advice based upon both conclusions.

1. How Fast are Prices Rising?

The rate of inflation cannot be given in a single number. The prices of different items rise at different rates at different times. Additionally, each individual or family experiences inflation differently because they each purchase different baskets of goods. Nevertheless investors need to have a general idea of how quickly prices are rising in order to invest successfully, and to prepare for future expenses.

Thus in this section I ask the simple question: "How fast are prices rising?" The CPI provides a simple-sounding answer to this question, when in fact it is an incredibly complicated piece of data, as I will make clear below. The best way to begin to answer this question is to simply look at the prices of things everybody has to buy, things that we buy on a regular basis, and maybe a few other things (for instance I look at the cost of Super Bowl tickets below even though most people do not go to the Super Bowl). Afterwards, in order to come up with a more general number, one could weight these items differently or adjust them in an infinite number of ways, but there is so much subjectivity and indeterminacy in doing so that it is my opinion that simply arriving at a flexible range is the most pragmatic and actionable approach to incorporating an inflation rate into any investment thesis.

What follows are a few examples of price changes over the past several years of things people buy. It is meant to provide readers with a general idea of what price inflation has really been in recent times.


With the bursting of the housing bubble home prices have risen only mildly in the 21st century. The Case Shiller home price index compiles data from 20 American cities.

The Case Shiller index was at approximately 100 in 2000, and it is currently (at the end of February, 2013) at roughly 146.6, which equates to an annualized rate of increase of roughly 3.2%.


Gasoline futures (wholesale prices) in 2000 were around $0.75 per gallon, and they currently trade at about $2.85 per gallon, which is an annualized increase of roughly 11.4%.

Retail prices have fared better from the consumer's perspective. In 2000 prices were about $1.25. According to AAA current prices are $3.63. This comes out to a 9% increase.

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Electricity prices have gone from roughly $0.08 per kilowatt hour in 2002, to $0.1225 today, which equates to a CAGR of roughly 3.8%

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Food prices obviously vary tremendously, so I will give several data points. According to the FAO food price index, which went from 90 in 2000 to 210 in 2013, the average rate of increase has been roughly 6.7%

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For some more specific data consider some example provided by A 2 liter bottle of Coca Cola cost $0.99 according to the Daily Record in 2002, and $1.99 at Foodtown in 2013, which is an annual increase of 6.5%.

In 2000 an 18 ounce box of Kellogg's (NYSE:K) Corn Flakes cost $2.99, or $0.16 per ounce. In 2013 a 12 ounce box of Kellogg's Corn Flakes cost $3.79, or $0.32 per ounce, which is a 5.5% annualized increase.

In 2003 a 1.55 ounce Hershey bar cost $0.80. In 2011 it cost $0.99, although the prices are from different stores. The annual rate of increase is 2.7%.

In 2004 a 1 pound box of Nabisco Oreos cost $2.99, or $0.19 per ounce. In 2013 a 14.3 ounce box cost $4.59 or $0.32 per ounce, an annualized increase of 6% per year.


The Milliman Healthcare Index, which measures the cost of healthcare for a typical family of four increase from $9,235 per year in 2002 to $20,728 per year in 2012, an annualized increase of 8.4% annually.

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NYC Subway Ride

In 2000 a NYC subway ride cost $1.50; now it costs $2.50, which is a 4% annualized increase.

Super Bowl Ticket Prices

In 2000 the most expensive Super Bowl tickets cost about $280; now they cost $1,200, which is a 12% annualized increase.

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Movie Ticket Prices

In 2000 the average movie ticket cost $5.39; in 2011 the price was $7.93, which is a 3.6% annualized increase.

Final Remarks

Again I must stress that this data only provides a partial picture of how prices have been rising during the 21st century. From the most important consumer goods for which I give data the price has been rising annually at a little more than 3% at the low end, and around 9% at the high end. Depending on the individual or family one could probably estimate that the inflation rate has been somewhere between 5% and 7%.

2. The CPI

The BLS's FAQ page provides readers with the following question and answer:

What is the CPI?

The Consumer Price Index is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. This sounds pretty straightforward.

Here is a chart of the CPI going back to 1984:

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The CPI has increased from 100 in 1984 to roughly 232.5 presently, which is about a 3% increase per year. Looking more specifically at the 21st century the index rose from about 167 (rough average for the year 2000) to 232.5, or a 2.7% increase per year. The conclusion drawn from this is that a basket of goods that a typical family or individual purchases has increased in price by 2.7% per year during the 21st century.

Intuitively this number seems to be too low. In fact, looking at the above data points this number is below that of every single asset that I sampled, with the exception of a Hershey Bar, which also increased in price at 2.7% per year. How, then, does the BLS arrive at such a low number?

Calculating the CPI

As I mentioned above the BLS has altered the methodology that it uses to calculate the CPI. If we look at what the CPI would be hypothetically if the BLS still used older methods, then the CPI would be significantly higher, and it would reflect more accurately the data that I provide above. John Williams of still calculates the CPI using two older methods: the "1980-based" and the "1990-based." I reproduce this data below.

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What has the BLS done to the CPI, and why do these alterations depress it?

The BLS employs two tactics that reduce the CPI. First, it incorporates what are called hedonic adjustments into the CPI. Let's say that a car costs $30,000 in 2010 and $33,000 in 2011. This should be represented as a 10% increase. But the BLS might claim that $1,500 of this $3,000 increase is due to improvements in the product, and so the price increase is only considered to be 5%. This makes sense. However there are a couple of issues with this theory. First, how is one to decide the value of an adjustment? If a hedonic adjustment adds value to a car because it is more fuel efficient, then the value of this change in the product will be greater to somebody who drives a lot than to somebody who drives infrequently. Second, hedonic adjustments have predominantly depressed the CPI, and it begs the question: is the BLS using hedonic adjustments in a way that increases the CPI? For example, the price of gasoline has increased by about 9% annually, but couldn't we add a hedonic adjustment for the fact that many gas stations have gone from full service to self service? Depending on how one values this aspect of purchasing gasoline the annualized price increase might be 10%. If hedonic adjustments that increased the inflation rate were included, my guess is that they would have a minimal impact on the overall inflation rate, which does not correspond to experience.

Second, the BLS uses what is called substitution bias. The idea here is that prices of certain items rise faster than others, and consequently consumers will switch from those items whose prices are rising more quickly to those items whose prices are rising more slowly. This might be the case for some products. For example, if the price of chocolate ice cream rises faster than the price of vanilla ice cream then one might be able to justify weighting the latter more in the CPI than the former. But this reasoning does not apply to essential items. Suppose that we lived in a world where there are only two products--clothing and food--and each product is 50% of the CPI. According to substitution bias if the price of clothing rises and the price of food remains the same, then people would spend more money on food than they did before the price increase. But if there is an individual who could barely afford these items before the price change what the BLS is essentially saying is that this individual will forgo clothing himself and eat more than he needs to. Yet it is natural to assume that this individual will attempt to find a way to cut down on his food consumption so that he can clothe himself.

While the academic validity of these adjustments are debatable, the empirical fact remains that they have lowered the CPI. Intuitively I believe that they are largely without merit given the observation that if we look at John Williams' data for the CPI as it would be calculated in 1980, it accurately reflects the data that I present in the previous section.

This begs the question: Is the BLS intentionally understating the CPI? While there is no conclusive evidence to this effect, the BLS is certainly financially and politically motivated to understate the CPI. This is the case for three reasons.

  1. First, if people believe that the CPI is accurate as it stands, then they will believe that inflation is lower than it really is, and they will consequently be more likely to hold dollars; this benefits the demand side of the supply-demand equation for dollars.
  2. Second, the government has expenditures that are directly correlated with the CPI. Government benefits such as Social Security are designed to increase with inflation, and cost of living adjustments are determined by the CPI. If the CPI understates the rate at which prices are rising then COLAs are smaller than they should be, which saves the government money. Also, the government issues inflation protected treasury bonds, or TIPS, that link payouts to bond-holders to the CPI. If the CPI understates inflation then TIPS payouts are lower which saves the government money.
  3. Third, GDP data is corrected for inflation as determined by the CPI. If the CPI understates inflation then the GDP appears to be larger and growing faster (or shrinking more slowly) than it really is. This in turn makes the government's economic policies appear to be more favorable than they really are, and the public will show greater support for spendthrift politicians.

While none of these observations is evidence that the BLS depresses the CPI, they do lead to the following conclusions:

  1. Americans are more likely to believe that the inflation rate is lower than the rate at which they are experiencing price increases for essential goods and services.
  2. Social security payments and TIPS coupons are significantly lower than they would be were inflation calculated as it was 33 years ago.
  3. U. S. GDP growth is stated to be much higher than it would be were inflation calculated as it was 33 years ago. In fact we would be in a deep, prolonged recession. The following is a chart of U. S. GDP taking this into consideration from John Williams. It shows that GDP growth would have been negative since 2005 were inflation calculated using the 1980 methodology.

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Final Remarks on the CPI

Economists and Wall Street analysts cite the CPI as if it were infallible. Even if you disagree with the specifics of my criticisms of how the BLS calculates the CPI, you must agree that the methods employed by the CPI are open to debate, and that at least in some respects the CPI severely understates the rate of inflation.

3. Prepare for Inflation Regardless ... You Can Always Hedge

Even if one disagrees with my assertion that there is significantly higher inflation than the CPI indicates, it is a good idea to include some inflation hedges in a well-balanced portfolio. After all, even if one believes that inflation is just 1.1% per year, there is no denying that the monetary base is increasing at a rate of roughly 33% per year, it there is a very real possibility that inflation could increase towards this number. In fact if the velocity of money starts to increase, or if credit begins to expand at a faster rate than the monetary base it is feasible that the rate of inflation could exceed 33% per year.

The easiest and most effective way to hedge against inflation is to buy commodities. Bonds have such a low rate of return that only the most speculative bonds will be able to offer investors the reward necessary to combat inflation after taxes. Foreign currencies can provide some protection against inflation but they can also be inflated, and in many cases foreign currencies are seeing increases in the monetary base that make them less appealing than the U. S. dollar. Many stocks will be good inflation hedges, but investing in stocks to hedge against inflation is difficult because while companies' sales may rise in line with, or in excess of inflation, their input costs will rise as well. This leaves commodities.

In particular I prefer commodities that have a high value to weight ratio, because these commodities are subject to lower storage costs. Also one doesn't necessarily have to resort to using futures contracts in order to hold these commodities: futures contracts expire, and consequently they have to be rolled over, which is costly and is potentially subject to losses as a result of contango. Oil, for instance, is a low value to weight commodity, and the United States Oil Fund LP (NYSEARCA:USO) uses oil futures in order to give investors exposure to the price of West Texas crude oil. Consider the following chart of the USO relative to the spot price of oil:

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The slow, yet steady downtrend illustrates my point perfectly. To minimize the cost of holding commodities investors should focus on positions in commodities that have a high value to weight ratio, which I point out in the following table:

Gold Gold investors should favor PHYS over GLD given that PHYS is taxed at the capital gains rate while GLD is taxed as a collectible. I discuss this in greater detail in my article: Buying and Owning Gold Part 2.
Silver As with gold, silver investors should favor PSLV over SLV for the same reason. I discuss this in greater detail in my article: Buying and Owning Silver Part 2.
Platinum and Palladium Investors should consider PLTM, PALL, and SPPP.
Investment Grade Precious Stones, Artwork, Rare Collectibles Investors require highly specialized knowledge, which I lack, in order to invest in these items.
Heavy Rare Earth Elements Investors should consider purchasing shares in OTCPK:DCHAF, which is a holding company focused on storing heavy rare earth elements.

Uranium has a lower value to weight ratio than the other investments listed here, however investors have access to shares of OTCPK:URPTF, which holds physical uranium based compounds with minimal storage fees, and so I include it in my list of high value to weight investments.

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4. Conclusion

The following points summarize this article:

  1. Many economists and investors believe that there is little to no inflation. This is the case because the CPI is increasing at a very slow rate (currently at just 1.1%).
  2. The supposed low rate of inflation is explained away as a result of a declining velocity of money, and minimal demand for credit. Those who believe that inflation is low believe that these phenomena are more powerful than the Federal Reserve's rapid increase in the monetary base.
  3. This viewpoint is questionable if one looks at the rate at which essential consumer goods are increasing in price. Some of these that illustrate my point include housing, food, energy and healthcare.
  4. There is a disconnect between the CPI and the rate at which these essential consumer goods are rising in price. This is the case because the BLS uses hedonic adjustments and substitutions in its calculation of the CPI. While there may be some academic merit to these adjustments, they suspiciously lead to the CPI showing that there is less inflation as evidenced by comparing the CPI as it is calculated today with the CPI as it would have been calculated if the adjustments were not put in place. Ultimately I believe that inflation is much higher than the CPI would have people believe.
  5. As a result investors should add inflation hedges to their portfolios. Even if investors do not agree with me they should do this because the rate of inflation cannot lag behind the rate at which the monetary base is increasing indefinitely. The simplest and most effective way to hedge against inflation is to purchase commodities that have a high value to weight ratio, as they have low storage costs.

Disclosure: I am long PSLV, OTCPK:URPTF, OTCPK:DCHAF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.