Moving The Goal Posts

by: Morningstar

By Samuel Lee

This article was published in the November 2013 issue of Morningstar ETFInvestor.

On March 11, 2011, the president of the Federal Reserve Bank of New York, William Dudley, lectured a working-class audience in Queens, New York, on why inflation wasn't a problem. A skeptical audience member asked, "When was the last time, sir, that you went grocery shopping?" The economist, a former Goldman Sachs partner with a Ph.D. from Berkeley, conceded that food and energy prices were rising, but pointed out that overall inflation was still tame. He went on to explain, "Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful."

The audience laughed.

After the presentation, an audience member said of the economist: "Tone deaf." Another quipped, "I can't eat an iPad."(1)

Dudley's speech was widely mocked and held up as an example of how out-of-touch the elite are with the common man.

Around the time of Dudley's speech, the University of Michigan inflation expectation survey of consumers registered a 4.6% median expected inflation over the next 12 months. The Bureau of Labor Statistics, however, only recorded a 2.6% year-over-year change in the Consumer Price Index. (In subsequent months, the CPI did catch up with consumer expectations, hitting a 3.9% year-over-year change in September.)

Historically, consumers' expected inflation closely tracked the trailing year-over-year change in the CPI. This isn't surprising; inflation expectations are strongly influenced by recent inflation. However, beginning in 2008, consumer inflation expectations began outpacing the CPI, averaging 1% more over the period.

In this context, conspiracy theories have gained some respectability. In a scathing Newsweek editorial, Harvard historian Niall Ferguson called the CPI a "bogus index." He cited John Williams' claim that the CPI, if calculated using its 1980 methodology, would report inflation of 10%.(2)

Rob Arnott piled on, stating the CPI understates inflation by 2%-4% relative to its historical methodology.(3)

Even famed value investor Seth Klarman has expressed skepticism of the index. In a letter to investors earlier this year, he wrote, "… [most people] know inflation is not well under control, for they know how far the purchasing power of a dollar has dropped when they go to the supermarket or service station."(4)

Are the inflation critics right? From what I can tell, their arguments boil down to the following: 1) Common sense and personal experience strongly suggest inflation is higher than the rate reported by the CPI; and 2) the government can't be trusted, as all its methodological adjustments to the CPI over the past 30 years have, suspiciously enough, lowered the rate of inflation.

They have a point. For most of its history, the CPI was calculated from a fixed-weight basket of goods, or a Laspeyres index. Starting in the 1980s, the BLS began moving away from the Laspeyres calculation to one that replaced housing prices with rental equivalence, expanded the use of hedonic regressions to account for quality changes, more quickly refreshed its fixed-weight baskets, and replaced arithmetic price-change averages with geometric averages for lower-level price indexes. Almost all the adjustments had the effect of lowering reported inflation relative to the previous methodologies. Indeed, the government has plausible incentives to move the goal posts: Social Security becomes less burdensome and economic growth looks better with slower-growing inflation.

However, I find it difficult to credit the skeptics' arguments, because the logical implications are ludicrous. According to government statistics, real gross domestic product has grown at a rate of 2.7% annualized from 1980 to 2013. Real per capita GDP has grown at an even slower rate, 1.6%, from 1980 to 2011. If true inflation was actually anywhere from 2% to 7% higher over this period, it implies the economy was either stagnant or experienced the worst 30 years in the nation's history, shrinking by 73% in real terms.

Moreover, there aren't the telltale signs the private sector distrusts government inflation statistics. Argentina's case is informative. Since 2007, Argentina has cooked inflation numbers coming out of INDEC, the national statistics bureau. INDEC has consistently reported 10%-11% inflation; private-sector economists reckon it's double that. Argentina's unions and corporations use private inflation estimates when negotiating contracts. The yields on Argentina's inflation-protected bonds have shot up since 2007, when worries about manipulation arose.(5)

You don't see any of that in the U.S. or global financial markets. Inflation swaps and the implied break-even inflation rate priced into Treasury Inflation-Protected Securities are largely consistent with the market believing the CPI is a reasonable proxy for inflation. The CPI is still widely used in escalator clauses between private parties who are under no obligation to resort to it as an inflation measure. The inflation critics are in effect claiming hundreds of billions of dollars of financial instruments are today mispriced because the market is relying on a flawed statistic.

The shallowness of their argument becomes apparent when you look at the premier source of "alternative" economic data, John Williams' Shadowstats. Williams claims that the U.S. economy has persistently shrunk since 2001. He has for years predicted an imminent hyperinflationary recession--his latest 2012 report predicts that the "outside timing on the hyperinflation remains 2014, but events of the last year have accelerated the movement toward this ultimate dollar catastrophe."(6)

Williams himself admitted in 2008 that, rather than performing the complicated task of collecting and computing the data necessary to calculate a CPI, he simply tacks on an "add factor" to the BLS' reported numbers.(7) If you subtract his adjusted CPI from the official CPI, the factor looks pretty much like a constant 7%.

The independent Billion Prices Project at MIT doesn't take such shortcuts. It calculates a daily price index for the United States by scraping hundreds of websites. Its index looks pretty much like the official numbers. Because the BPP index is refreshed daily, it has been able to anticipate changes in the reported CPI. To explain this neat coincidence under the hypothesis that the government is manipulating the CPI, either the professors at MIT are in cahoots with the government or they've somehow secretly cracked the government algorithm to manipulate the CPI.

Finally, I couldn't find a single instance of an insider blowing the whistle on CPI manipulation. If the nation's most secretive department, the National Security Agency, has experienced multiple leaks over the past decade, it's awfully strange no one at the BLS has blown the whistle on the government's malign manipulations.

Occam's Razor
That still leaves us with the unassailable empirical fact that many consumers believe their personal rate of inflation is higher than what the CPI indicates. Rather than invoke conspiracy theories, I think the discrepancy is best explained by psychology and the way the CPI is calculated.

The brain substitutes difficult questions with easier ones. When confronted with the question of how much have overall prices risen, rather than carefully computing the price change in an expenditure-weighted basket of goods and services, many consumers instead recall price changes for things they buy frequently--food, gas, and so on--while underweighting or ignoring the price changes of things they infrequently buy, such as cars and houses. The CPI, on the other hand, assigns about a 15% weighting to food and beverages, 5% to fuel, and a massive 40% weighting to housing and related expenditures (such as appliances, furnishings, and so forth).

There's even a perfectly good, logical reason the changes to the CPI calculation seem to adjust inflation down. The BLS defines inflation as the change in the cost to maintain a constant standard of living. By that, it means constant utility, or constant "happiness." Because happiness can't be directly measured, it has to be inferred. With some undemanding assumptions, it can be shown that the fixed-weight Laspeyres index is the absolute upper bound for a true cost-of-living index, because it fails to account for substitution and quality improvements.

Starting at least in 1961 with the Stigler Commission, the expert consensus has been that a cost-of-living index is the ideal way to measure inflation. Decades before that, in 1939, economist John Hicks demonstrated that a fixed-weight index overstates inflation in the case of quality improvements or the introduction of new products.

However, the BLS kept the fixed-basket Laspeyres index calculation because it's easy to compute, easy to understand, and within the technological and resources constraints of the times. Calculating a true cost-of-living index is a massive undertaking. It should be no surprise that as statistical methodology has gotten better and computers cheaper, the BLS would begin moving toward the economists' ideal index.

Crying Wolf
During the financial crisis, the Federal Reserve began a slew of unconventional monetary programs to pump liquidity into the markets. There were two opposed schools of thought on the effects of the Fed's moves: The inflationistas predicted the Fed risked massive inflation and surging interest rates; the deflationistas predicted low inflation and interest rates.

I can't help but notice the people most loudly proclaiming that inflation is actually really high and that government stats are bogus were inflationistas back then. I've struggled to find the doomsayers complaining about bogus inflation statistics prior to 2008. I'm sure some of them did. However, it's hard to shake the impression that rather than change their minds or admit they were wrong, the failed prognosticators have resorted to moving the goal posts.

(1) Cooke, K. "For Fed's Dudley, iPad Comment Falls Flat in Queens." Reuters, March 11, 2011.
(2) Ferguson, N. "Sticker Shock." Newsweek, May 1, 2011.
(3) Arnott, R. "The Long View--Building the 3-D Shelter," Fundamentals, Oct. 2011.
(4) Quoted by Howard Markets, "The Role of Confidence." Oaktree, Aug. 5, 2013.
(5) Helft, D. "Argentina Inflation-Linked Bonds Fall on Investor CPI Pessimism," Bloomberg, June 21, 2007.
(6) Williams, J. "Hyperinflation Special Report 2012." Shadow Government Statistics, Jan. 25, 2012.
(7) Hamilton, J. "Shadowstats Reponds," Econbrowser, Oct. 12, 2008.