Who's Wrong About Inflation?

In a recent Bloomberg article, consumers' inflation expectations appear to differ quite markedly compared to investors' inflation expectations.

Consumers expect prices to rise 5.2 percent in the next 12 months, according to a monthly survey by the University of Michigan in Ann Arbor, the most pessimistic they've been since 1982. Treasury Inflation Protected Securities, or TIPS, show traders anticipate inflation of about 2.95 percent by January, in line with its average of 3.1 percent the last 20 years.

The question then is, who is wrong? Is it:

a.) consumers

b.) investors

Or maybe they are both right. But, how can this be?

Consider what TIPS are.

Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.

The key to this paragraph is "Consumer Price Index."

The consumer price index is a basket of goods measured by the Bureau of Labor Statistics [BLS]. Each month, the BLS surveys businesses on the prices in that basket of goods and compiles the data to calculate the CPI.

However, calculation of the CPI includes hedonic adjustments, which are adjustments to the data to account for changes in quality. For example, a computer that costs $500 today is of far higher quality than a computer that cost $500 two years ago. If the computer today is twice as good as it was two years ago, the government adjusts the price down today by half to account for the change in quality.

This is logically consistent. If a consumer is getting better value for a specific good at the same price, the cost per unit of value has fallen, as a result, inflation for that good has fallen.

However, concern has risen about the hedonic adjustments to the CPI. Critics have argued that hedonic adjustments are underestimating inflation, and that by making too many adjustments, the BLS is mis-calculating true inflation. The critics also contend that the construction of the CPI does not accurately represent the components of the economy.

Thus, both consumers and investors may accurately be forecasting inflation as they specify it.

Consumers experience inflation on a daily basis. Investors in TIPS are compensated based on the CPI. If the construction of the CPI is wrong, then there can be a wide disparity between inflation expectations of investors and what consumers are seeing on the store shelves.

Let us then add another option to who is wrong about inflation:

c.) the government

Choosing between (a), (b) and (c), my guess is (c). Based on my own personal experiences, I think the government is understating inflation.

Comments

[VennData:]

Why doesn't one of the few remaining CDO /swap packagers put together a swap between the consumer expectations and the TIPs?

2008 May 20 07:03 AM

[notsosmart:]

since the consumer needs food & energy everyday there should be a monthly inflation accounting for this. who cares if a computer is 2x as good as it was 2 years ago. how often does a consumer buy a computer etc. just another scam folks. wake up america.

2008 May 20 08:39 AM

[Yiani:]

The government is understating inflation. The adjustment for "a computer that costs $500 today is of far higher quality than a computer that cost $500 two years ago", is erroneous. Most consumers rarely benefit on an one-to-one basis by the higher quality of their new computer. Price increases on food and energy, on the other hand, are affecting everyone every day.

2008 May 20 09:00 AM

[Jimbo:]

If a private individual or business were to engage in the kind of statistical manipulation the government is doing, there would be angry congressional hearings demanding the Department of Justice undertake a prosecution. I wonder if former senator John Edwards will launch a pro-bono lawsuit on behalf of all citizens accusing the government of malpractice? Don't expect future President Obama to set this right either.

2008 May 20 09:15 AM

[Fabien Hug:]

It is like the GPS in a car. Bang, $ 1,500 more and you use it 2 times/year on average but you have a great hedonistic experience. Another great hedonistic experience is Windows Vista and the very expensive PC you must purchase to run it.

2008 May 20 09:34 AM

[Nick from G...:]

It's hard for me to fathom how inflation has not shown up in the numbers unless there is a significant lag between certain input costs such as food and petroleum products with the finished products that everyone buys. Expenses have gone up so much, it's painful to watch the bulls get so excited at the most recent rally.

Position: Short QQQQ and SPY

2008 May 20 09:36 AM

[Managing Ed...:]

Notsosmart - There ARE monthly indexes of food and energy inflation maintained by the Bureau of Labor Statistics. They're included in each CPI report, though you'll usually need to scroll through a few lines in the report to find 'em.

2008 May 20 09:46 AM

[CaptBob:]

M. Editor:
That may be true, but let’s take a look at what actually happens with consumer prices. As Always, we need to point out that there are four different Consumer Price Index readings released by the Statistics Bureau each month. These are the ‘general’ index, ‘general’ excluding rent, the ‘core’ index and the ‘core’ index without energy prices included. Some like Japan includes energy costs in core CPI.

* General nationwide consumer price index:
* General nationwide consumer price index (excluding rent):
* Nationwide core CPI (excluding fresh food):
* Nationwide consumer price index (excluding fresh food and energy):

Don't-cha just love that last one?? Well the govt. sure does cause that's what you get as an inflation measure!.
Wouldn't want things that are too "volitile" linked to "Inflationary" increases in program payments like Social Security now would we??.
Gotta love that "Core inflation"
Reminds me of an apple where all the meat is gone and you're left with the "CORE"!!

The more complex you make it the Less Joe taxpayer-(with the deep pockets) is gonna understand it and the more he's gonna love you--just like a 1040 with accompanying rules.

2008 May 20 10:46 AM

[nScout:]

If all your budget ends up going into food and energy what do you care about the price of "discretionary" goods. Bureaucrats need to constantly invent concepts, useless as they may be, to justify expanding their offices at the taxpayer's expense. By the way, is there a "price of government" index?

2008 May 20 11:19 AM

[BerkeleyBob:]

Sound fiscal and monetary policy requires accurate data and close examination of the underlying premises. The falseness of the CPI has been with us for a while, but clearly taken to new heights of mendacity by this administration.

2008 May 20 12:28 PM

[notsosmart:]

i thank the managing editor for this info. i did not know it. how many do? it should be on the front burner for everyone because everyone is feeling it.cmon-you know its all a scam & a game.some win but most of us lose.

2008 May 20 12:30 PM

[gordon:]

The corrupt TIPS will be ZERO base rate on the next offering, meaning an investor is counting on the gov't inflation above that for yield. GOOD LUCK! They are purposely driving money into stocks as investment of last resort. TIPS yield could be 2.5% or less, even NEGATIVE in the future.
Here's an explanation of the BLS corruption on gasoline CPI prices, make sure we all watch them (put them on notice!) to see they raise it later in the year to compensate for the "seosonal adjmt>)
ftalphaville.ft.com/bl.../

2008 May 20 03:28 PM

[the final h...:]

oh please....let me give one SIMPLE example:

a bottle of (off-brand) bleach used to be one gallon for $.79...then it went to 3 quarts for $.79...then it went to 3 quarts for $.99...then it went to 3 quarts for $1.29. i havent checked it lately.

this doesnt include the quality reduction.

and you believe the government?

2008 May 20 05:14 PM

[carey_jim:]

The comic book character Pogo said, "I have seen the enemy and he is us."

Human beings are not as different, from one culture to another, as sometimes believed. We in the United States demonized the Soviet Union during the Cold War, from the 1930's to 1990, only to look away from qualities we thought were unique to the Soviet Union: a virulent and often out of control secret service organization, a very small, self-perpetuating ruling class, a consuming thirst for military power and, finally, but perhaps most dangerous, a propaganda machine that defines the "truth" to suit its own purposes.

We've defeated the Soviet Union but how do we defeat a more difficult enemy: us?

2008 May 22 12:49 AM