Consumer Price Index: More Detached from Reality Each Day

By Matthew Hougan

The consumer price index gets more and more detached from reality each day.

Consider this: According to the Bureau of Labor Statistics, the average "blue collar" American spends more money on cigarettes than on prescription drugs.

Specifically, the 2007 weighting table for the CPI-W shows the average American spending 0.998% of his income on prescription drugs and just 1.183% on tobacco products.

That's not the only howler.

We spend nearly as much on booze (1.025%) as on doctors (1.123%), and basically the same amount on personal care products like shampoo (2.35%) as we do on education (2.37%).

The list goes on.

To be clear, this is not the CPI that gets reported each month in the press. That's the CPI-U, and the numbers are slightly different.

But the CPI-W is hugely important. It's used to make cost-of-living adjustments to Social Security, so it impacts the checks that millions of American seniors receive each month.

And as I've said before, it's not just the weightings, either. The use of tools like substitution and hedonic regression have rendered the CPI all but useless. It's not just that it's a bad index, it's been deliberately manipulated to understate real "lived" inflation, with major consequences for everyone who relies on cost-of-living adjustments.

Comments

[jackh]

Brought to you by the same folks who have raised the normal retirement age to 67.......

Why are the young folks not making this an issue with the November vote drawing near???

Raise retirement age... let social security lag the CPI.... no one seems to care.... perhaps we'll get the president we deserve.....

[Skjellifetti]

In other words, this author does not want to correct the CPI for quality changes even though the car you buy today is much safer (and therefor not the same car) as the one you bought 30 years ago. Ignoring the quality differences means that costs today cannot be compared to costs yesterday because you are not comparing the same goods, thus rendering the CPI a meaningless measure of actual cost changes faced by consumers over time.

The author sounds like he thinks all SS recipients should be entitled to purchase flat panel HDTVs at the same cost as their soon-to-be-outdated analog vacuum tube model or else they might starve to death.

[icandoitdon]

i don't have any trouble with adjustments to reflect quality improvements that extend the life of a product. but mandated safety improvements i don't need or want that i am forced to pay for? i don't think so. mandated costs that reduce consumer choice should be fully measured.

neither it realistic to assume that consumers freely substitute products if the prices of one get "out of line." it would take a disproportiotely large price increase to force such changes in consumer behavior. case in point: high gasoline prices should force consumers to drive less, right? gas prices have doubled but it has barely dented consumption.

my issue with the CPI is that it is a "black box" that is easily subject to manipulation; and the government has the largest vested interest of anyone to keeping the CPI low. i simply don't believe that their bias does not affect their results.

as for all SS receipents thinking they're entitled to HDTVs, i think that's a bit of an exxageration, don't you? they do vote their self interest which, i suspect, is exactly what everyone else in this country does. it's called democracy.

[Mike Stathis]

Well said Matt. I also address this in "Stay Clear of Traditional Asset Classes."

I'd like to add that an additional problem with the use of hedonics is that it assumes ALL goods/services with improved features (assuming price stays constant) will provide perpetual benefit to consumers. In fact, only goods and services that are depleted daily are remotely applicable for a prudent use of hedonics, such as gas, food, etc. But ask yourself how many TVs, cars or consumer electronics you buy every year. Yet, this is where most of the deflationary effect of hedonics arises.

Hedonics especially understates inflation during periods of tight credit and/or economic contractions because, regardless how many improvements to goods/services have occurred, consumers will tend to disregard this effect. In other words, if you don't have money to buy an LCD, the fact that the screen is bigger while the price is the same doesn't matter.

Washington is able to undermine the real inflation rate by adding deflationary components due to improved electronic appliances, computers, cars, etc. to the inflation rate of gasoline and food. This largely offsets the total inflation. It doesn't take a genius to see that the real inflation rate is around 10%. All you have to do is check your wallet.

Ironically, the consumers who have the best feel for inflation are unfortunately the ones who are struggling the most since even the smallest of price increases are felt immediately. I find it a mockery that these consumers have a better understanding of the real inflation fate than Washington's hired-gun economists.

[Skjellifetti]

icandoitdon --

"mandated costs that reduce consumer choice should be fully measured."

This is a valid point.

"it would take a disproportiotely large price increase to force such changes in consumer behavior."

Er, no. This depends on the good in question. Substitution effects between, say, beef and chicken as relative prices change are well documented. Gas use has measurably declined in recent months.

"my issue with the CPI is that it is a "black box" that is easily subject to manipulation"

The CPI is in no way a black box. See www.bls.gov/CPI The amount of research done every year on the CPI and consumer demand for products such as food, gas, autos, and housing by gov't, academia, and private enterprise is prodigious and usually available for anyone to review.

Mike Stathis --

"But ask yourself how many TVs, cars or consumer electronics you buy every year. Yet, this is where most of the deflationary effect of hedonics arises."

CPI is an aggregate measure, and in aggregate, people buy an awful lot of TVs every year.

"Ironically, the consumers who have the best feel for inflation are unfortunately the ones who are struggling the most since even the smallest of price increases are felt immediately."

The CPI has to measure everyone's consumption costs, not just the poor. It must include the middle class and the rich as well. In fact, the BLS does provide sub indexes for different groups of consumers.

[mark van]

ss recipients deserve their ss checks and the proper increases each year for living costs...this is not an entitlement it is a state offered insurance or pension...everyone pays into it and everyone deserves the benefits of it... the state should properly manage it and you die hard rebuplicans who believe in less government and that government cannot do anything right should go fu** yourselves, it is the republicans that have increased government spending and the size of government, it is the republicans that gives tons of tax payers money to corporations in the form immoral of tax cuts,,,
ss it is not an entitlement.....

[Skjellifetti]

"ss recipients deserve their ss checks and the proper increases each year for living costs"

Yes, they do. For real increases in the cost of living. Not imaginary increases due to improved quality of the goods available in the economy.

Were you aware that SS was indexed in the 1960s under LBJ to take account not just of the increased cost of living, but of the increase in real average hourly pay rates as well? That means that SS became no longer a retirement benefit, but a requirement that younger generations were going to have to fork over part of their pay increases due to improved productivity to the previous generation. That change did, in fact, make part of SS a welfare payment from the young to the old instead of just a retirement plan.

TANSTAAFL

[Jimbo]

I have to support Mike Stathis in this issue. As a retiree I have not bought a TV, improved or otherwise, in ten years. I am now paying $3.89 for a loaf of bread that cost me $2.50 last year. The cost of energy insidiously drives up the cost of all goods and services. Hedonics shmedonics!!

[icandoitdon]

Skjellifetti:

you gave me one out of 3 so i'm going to try to improve my score.

on product substitution:

my larger point is this: many things have relatively inelastic demand curves and/or stable sources of demand, where price makes little difference. this is true with myriads of consumer products. let's take your example cited:

some like beef...others chicken...others fish. the CPI assumes that a 10% increase in price of one relative to the others causes a proportionate shift in consumption; in doing so it ignores consumer preferences and what people are willing to pay to satisfy them.

having said that, at some point people will obviously start to make substitutions. but it's an unknown...some will change sooner and others later. to assume price changes force substitution in fuid fashion doesn't reflect reality in my view.

regarding my view that the CPI is a black box:

thanks for the link...i did look.

i confess that my "black box" comment was a bit of a broad swipe about something of which i lack detailed knowledge. but my point was a larger one....it is not simple index to understand or relate to. when the government claims that inflation today runs at around 3-4% annually when food and fuel, two of the biggest single expense items of most households, are up 20 and 50% over the last year,it doesn't exactly enhance it's credibility.

perhaps what's needed is two gauges...adjusted and unadjusted. at least the public would then understand the impact of the adjustments made. but maybe that's why it isn't offered...

[Skjellifetti]

Best recent article on the CPI...

www.nytimes.com/2008/0...

Be sure and look at the interactive graphic...

www.nytimes.com/intera...