The CPI Understates Inflation And Skews Expectations

The Importance Of How the CPI Is Figured Is Massive

Consumer inflation has been estimated since the 1700s by measuring price changes in a fixed-weight basket of goods. This method was seen as effectively measuring the cost of maintaining a constant standard of living. In the last 30 years, a growing gap has become obvious between government reporting of inflation, as measured by the consumer price index (CPI), and the perceptions of actual inflation held by the general public. Informal evidence and occasional surveys have indicated that the general public believes inflation is running well above official reporting, and that public perceptions tend to mirror the inflation experience that once was reflected in the government's formal CPI reporting. The government is able to understate inflation by using methodologies based on the concept of a "constant level of satisfaction" that evolved during the first half of the 20th century in academia.

The numbers the government pumps out today are the result of changes made in the 1990s when political Washington moved to change the nature of the CPI. The contention was that the CPI overstated inflation by not allowing for the substitution of less-expensive hamburger for more expensive steak. This extended into the BLS re-weightings sales outlets such as discount or mass merchandisers with Main Street shops. Those promoting the change claim it is simply another way to measure inflation and it still reflects the true cost of living. Politicians and the financial media touted the benefits of a "more accurate" CPI that would allow for the substitution of goods and services. This was viewed as a way to reduce the cost of living adjustments for government payments to Social Security recipients, etc. The fact is that by moving to a substitution-based index and weakening other constant-standard-of-living ties have muddied the water as to just how much we are being impacted by inflation.

The general argument was that changing relative costs of goods results in consumers substituting less-expensive goods for more expensive goods. Allowing for a substitution of goods within the formerly "fixed-basket" would allow the consumer to attain a "constant level of satisfaction." This adjustment to the inflation measure was touted as more appropriate for the GDP concept in measuring shifting demand and weighting actual consumption, rather than using a fixed more ridged weightings when assessing the costs of maintaining a constant standard of living. Other tricks were also used, where the quality of the product was deemed by the government to have improved, this is something that has occurred throughout history, but prices in the CPI calculations are now adjusted lower to offset the higher quality. Extending this idea, the Baskin Commission Report, December 4, 1996, actually used steak and chicken for its substitution example.

The cuts in reported inflation were an effort to reduce the federal deficit without anyone in Congress having to do the politically impossible which was to register a vote that would harm the image of Social Security. These changes were promoted under the cover of academic theories. Katharine G. Abraham, then commissioner of the Bureau of Labor Statistics, laid out her recollections in an August 1996 paper: "Back in the early winter of 1995, Federal Reserve Board Chairman Alan Greenspan testified before the Congress that he thought the CPI substantially overstated the rate of growth in the cost of living. Greenspan's testimony generated a considerable amount of discussion but the general public paid little if any attention."

What is important here is that the purchasing consumer is often not given a choice when paying out-of-pocket the full price for a product or has little or no concept of the quality improvement being acquired or the chance to opt out of paying for an improvement they do not want or need. One example is the government mandated use of a gasoline formulation that was to improve auto emissions. It added ten cents per gallon to gasoline costs, but that cost was excluded from CPI calculations even though the person filling his or her gas tank suffered the actual out-of-pocket expense. This is also clearly seen in new computer and television features usually that are deemed quality improvements, these result in downside price adjustments made in the CPI for the changes that a consumer may not have wanted or used.

The bottom-line here is that consumer concerns are for his or her out-of-pocket expenses. They care only about what they are paying for textbooks this semester or what they are paying out-of-pocket to fly from New York to Chicago and the actual out-of-pocket expense for a computer. According to the way things are figured it is cooked in the numbers that even if they may be looking just to use limited functions the numbers are adjusted so that they have no choice but to value unwanted features. Because of the above and because the effects are cumulative going forward over time, the CPI has become less of a reflection of true inflation or even meaningless to the public.

While the substitution-related alterations to inflation methodologies were made beginning in the mid-1990s, the introduction of major changes to concepts geared towards making us feel better about things began in the 1980s. The aggregate impact of the reporting changes since 1980 has been to reduce the reported level of annual CPI inflation by roughly seven percentage points meaning there is no question as to the understatement of inflation. If the methodological changes did not reduce CPI inflation reporting meaningfully, the politicians would not have pushed the changes of recent decades. The important issue is that without these changes, Social Security checks would be more than double what they are today.

To understand how just how large the impact has been on the CPI, it is important to note that fully 24.0% of the total current CPI-U inflation reporting reflects the category of "homeowners' equivalent rent of residences." Instead of reflecting some measure of home prices, as was the case before 1983, the BLS estimates the cost of housing based on what homeowners theoretically would pay to themselves in order to rent their own homes from themselves. The BLS then estimates how much homeowners raise the rent on themselves each month. Starting in 1989, the BLS "improved" these estimates by beginning to adjust that imaginary series for quality adjustments that would make the consumer feel good or better enjoy their residence.

Years ago when America was experiencing what the late Allen Meltzer described as "The Great Inflation", his take was that inflation generally was not considered a major problem or issue until it rose into the double-digit area. I contend that all this manipulation of data and artificially lowering the official rate of inflation feeds into the illusion of both stability and that we are experiencing an economic recovery. The idea inflation is not and will not become a problem is used by individuals to plan and make decisions concerning their investments and income. I further contend that inflation would be much greater if more money was flowing into tangible goods rather than paper investments and promises. For proof as to the real cost of inflation, just look at the surging replacement cost resulting from recent storms and natural disasters. Those taking the CPI numbers that are currently being reported to heart are vulnerable to future economic risk.