Consumer Price Index (CPI): Does It Measure Inflation?

Discussion in 'Economics' started by MSWilliams, Feb 28, 2013.

  1. <b>What is Inflation?</b>

    Before we discuss the CPI and government economic data, we much first fully understand the concept of inflation. Inflation, in the most general terms, is a RISE in price levels of goods and services measured over a period of time. When price levels rise, each unit of currency buys fewer goods and services. Inflation also measures the erosion in purchasing power of money, the loss of REAL value in the medium of exchange. Inflation impacts everyone in society, rich or poor, young or old, working or unemployed. Anyone that has to buy food, goods, and services, pay bills, or transact in the economy is directly affected by inflation.


    <b>The CPI - official measure of inflation.</b>

    The government's key measurement for inflation is known as the CPI (Consumer Price Index). It has been around since 1913 and traditionally measured a basket of goods, which consumers would purchase. Then the price the basket of goods was compared on a year-over-year basis.

    For instance you price a steak, a loaf of bread, a gallon of milk, etc. The following year you price the same products, look at the price change, and you are able to determine the rate of inflation. How much have items increased in price. That is (was) the purpose of the CPI, the rate of change on a fixed basket of goods (with a modicum of replacements when a product is no longer serving its core use, such a computer for a typewriter).

    The CPI is very important data point for a couple of key reasons:

    1. Used to adjust Social Security benefits.
    2. The Federal Reserve uses it as their key measure of inflation to adjust monetary policy.

    Obviously a lower CPI would be beneficial for both those key reasons.


    <b>The Cost of Living?</b>

    When the CPI came about it was used to strictly measure INFLATION, as described above. It did so for 70 years without any major changes. More recently in the last few decades, the model used for calculating the CPI has changed drastically. In fact, it no longer measures inflation, but rather the "cost of living".

    The Cost of Living measures the CHOICES a consumer has made based on price changes. In fact INFLATION directly impacts those choices. Many of the changes that have been made to the CPI over recent years have been argued based on the Cost of Living and the freedom of choice. It would seem a sound argument if we forget the purpose of the CPI to measure inflation.

    The "Cost of Living" is not synonymous with inflation, yet politicians and the media frequently use the words "inflation" and "cost of living" interchangeably.


    <b>The philosophy behind the changes.</b>

    The first big change was made in the mid 1980s, it removed housing from the CPI and replaced it with a "rental equivalent". It was argued that not everyone buys a house and some that do buy also rent homes, thus we should measure the inflation of rent rather than the inflation of home prices. This made a significant and measurable change to the CPI and lowered the results.

    However, it was the "Cost of Living" argument in the 1990s that brought forth the largest changes. A powerful argument based on measuring the "Cost of Living" and freedom of choice. The belief was the CPI was not reflective of consumer choices, that consumers would make changes in their purchasing to meet a Standard of Living. In order to measure this Cost of Living, we must make significant changes to the method and make some "adjustments".

    ----next part 2----
  2. These major changes fell into three distinct areas:
    • Substitution
    • Hedonics
    • Geometric Weighting.

    These three changes to the CPI model radically changed the results. For the first time in almost 80 years we were no longer measuring inflation, but instead measuring the "Cost of Living".


    Substitution Method

    The first big change made to the CPI model was the Substitution Method.

    In the 90's it was argued by Boskin (brief bio: Dr. Michael Boskin, chairman of the Council of Economic Advisors 89-93, was the chairman of the Commission on the Consumer Price Index, whose report transformed the way the government measured inflation, GDP and productivity. ) that CPI was over stating inflation and a method he had been working on would give a more accurate measure of inflation. His argument was, "We should allow for substitution here because people can buy hamburger instead of steak, when steak the price of steak goes up." While it correctly points out people's freedom of choice, it clearly does not measure inflation. The consumer purchasing hamburger doesn't change the fact that steak has increased in price. Clearly the substitution method hides or masks the actual impact of inflation.

    The term "Cost of Living" was best defined, perhaps by accident, by Boskin, who was trying to phrase the substitution changes, but realized that it impacted the Standard of Living. The model he used had been known as the Utility of Living (or Utility Efficiency), this is defined as the cost of meeting the essentials REGARDLESS of the standards. By the definition, the Utility of Living is met by purchasing hamburger instead of steak, since they both offer protein. However, it is clear that the Standard of Living has declined significantly, even though the Utility of Living has met its burden.

    The "Cost of Living" soon became the standard term used with the CPI, however I think most people missed the real definition and mistakenly assumed it meant the same thing as "inflation".

    For those not familiar with the substitution methodology, I have included some text from the Bureau of Labor and Statistic (BLS) website used as an example of this methodology. It clearly sheds light on the fact that while a certain level of Utility of Living is met, the Standards of Living could be significantly lowered. Yet, most importantly, the substitutions mask the REAL impact of inflation.



    The CPI additionally receives an adjustment to the cost of a product based on the product's "Ease of Use" or "Lifestyle Benefit". The idea is that technology has benefited our lives, so the cost that the consumer pays for the product would be artificially reduce by its "ease of use" when calculating the CPI. This is known as Hedonics and reduces the cost of the goods in substituted basket.

    How you actually measure Hedonics and determine the reduction in the calculation even leaves some economists scratching their heads. Not only is it subjective, the mathematical impact further reduces the CPI data.

    I understand that our life styles through the increase of technology have benefited, but to tell people that we are going to artificially reduce the cost of the product when calculating CPI because she/he received a lifestyle benefit is silly. Why, because the consumer did not receive a discount when they bought it.


    Geometric Weighting

    Geometric weighting works hand-n-hand with the substitution method and determines the weighting of an item in the basket of goods based on price changes.

    If the price of an item that is measured increases, they LOWER the weight of that item to reduce the impact of the price increase.

    The argument is that if the price goes up you will buy less of it and theoretically that makes sense. However, you still need eat, pay for gas, pay your bills, etc.

    If the price impact is TOO much then they substitute the product out for something else, again making the assumption that the consumer will buy something different because the item cost too much.

    There is nothing wrong with this approach IF and only IF you want to measure the Cost of Living based on a certain income and how inflation impacts people's purchasing decision.

    However, and this is VERY IMPORTANT, this approach is NOT measuring inflation but rather how REAL inflation is impacting consumer spending habits.

    However, the Geometric Weighting system LOWERS the amount of MILK weighting in the basket because it is making the assumption you are buying less of it because it is more expensive. Theoretically this is true to a certain extent. However, we still need to eat, buy gas, etc.

    The fact is the price of Milk increased by 20%, regardless of the consumers decision to purchase it or something else, or less of it.

    <---next part 3: conclusion ---->
  3. Conclusion

    While all these changes directly impacts the CPI, the broader problem is that the Federal Government and Federal Reserve report this as the "official" measure of INFLATION and use the words "cost of living" and "inflation" synonymously. The problem is clearly one of semantics. We are told the government is measuring inflation, when clearly they are measuring something different.

    It's a semantics problem that the International Labor Organization (ILO) has clearly addressed when this question was posed to them about measuring inflation:

    Which of the two types of index (i.e. a fixed basket index CPI and Cost of Living index COLI) is preferable as a means of measuring inflation?

    It is interesting that the ILO simply relates the different opposing views and does not say that one is correct or the other is wrong, just different. Furthermore it is clear that you can't replace one with the other, as you are measuring two different things, Price Changes vs. effect of those prices changes to the Cost of Living.

    I spoke with the ILO about the CPI vs. COLI subject. They stated you can NOT replace one with the other, they measure two different things. One measures inflation based on price changes, the other measures the Cost of Living based on "utility efficiency". When asked about the U.S. CPI method, the ILO stated it is a Consumer Cost of Living that is now being used as the current method of measuring inflation, not the traditional fixed basket of goods. I asked which is better; they said depends on what you want to measure. However, you cannot say one is the other, because they are not.

    It's interesting to note that measuring the Consumer Cost of Living (COLI method) is impacted by inflation affects from the fixed basket of goods, as consumer substitutions must change to avoid price increases, the definition of substitution.


    Comparing: CPI original model (inflation) vs. CPI current model ("Cost of Living")

    The official CPI (currently used) is reporting inflation as of 2012 at 2.07%

    If we remove the 1990s changes that converted the model to a "Cost of Living" from the original INFLATION method, the CPI reads as of 2012 at 9.68%

    That is a 367% difference.

    However, even using the current "official" CPI method for reporting inflation at a artificially low 2.07%, you will still lose money purchasing a 10 year treasury that yields 1.8%.

    Currently the Obama Administration is considering another change to the CPI to the new C-CPI-U model, which further lowers the CPI results by 50 basis points. It is been explained by government officials that it is even more accurate.
  4. Ed Breen

    Ed Breen

    MSWilliams, the issue in defining inflation is how the definition can distinguish with a general price change in all goods and services over time that is caused by monetary policy as distinct from changes in goods and services that is caused by changes in supply and demand.

    This is complicated becuase chronic monetary inflation or monetary policy mis-management has an effect on capital investment which in the fullness of time impacts on supply and demand issues. For instance, the U.S. Fed reserve during the late 1990's managed monetary policy so that the value of the dollar soared and the value of commodities might remember that oil (WTI) traded as low as $10 a barrel. This was a deflationary monetary policy mistake, but the effect was to eliminate investment in oil exploration, production and transportation. The same happened in mining generally. Long project investment dried up and a generation of project engineers and skilled production personal was never developed. In the following decades, until very recently the supply demand issue in oil and strategic metals has distorted becuase of the lost capacity from the earlier monetary mistake.

    I just lay this out to say that determining the effect of monetary policy on inflation as distinct from supply and demand imbalances is not as straight forward as you might think.

    If price change is driven by supply and demand imbalances then the price anomaly is self correcting as higher prices will eventually lead to incresed production. You can argue that we are seing that now in the increased oil and gas supplies brought on by 'fracking' technology that is very much a response to high oil prices.

    So, in measuring inflation for the purpose of monetary policy you have to break out supply and demand price changes. This is why the CBs tend to use the Core Index rather than the regular index or the chained index. It is thought that the Core index that eliminates changes in oil an food has less supply demand distortion than the regular index. For the same reason the U.S. fed uses the PCE as its inflation policy index rather than the CPI and the U.S. fed follows the Core PCE.

    Another aspect in considering how to measure monetary inflation is the nature of the economy you are looking at. A mature and complex developed economy will have prior monetary policy embedded in its structure of economic contracts. If the value of a currency has been relatively stable over time, labor contracts, debt contracts, supply agreements, leases and all order of long term agreements will exist. When a monetary inflaton begins to take hold it will have to work through the contract basis of the economy in time as long term contracts mature or are broken. So, an economy like the use can take decades to fully express a monetary inflation. In a lesser developed economy, say one based on a small set of exports, commodities, or in an economy that has a history of periodic inflation and devaluation in its currency there wont be so many long term contracts or there will be contract provisions to change prices with inflation. In such economies an inflation will manifest much more quickly.

    Now, lets consider what monetary context causes a broad increase in prices in a mature economy. Illl get back to this later, gotta run...think about private credit formation as velocity in the mean time.
  5. maler


    I do not know another simple topic wrapped in more sophistication
    and obfuscation than money.
    The vast majority of humans take the blue pill. Taking the red pill
    can get you severely depressed.
  6. Ed Breen

    Ed Breen

    Cutting to the a fiat money system where money is not collaterized the idea of base moeny and credit merge. Notions of money supply become dominated by the amount of private credit outstanding and the amount of private credit outstanding modulates in a dynamic relationship with the value of collateral assets on which such credit is based. Inflation occurs when capital flows into tangible assets on an accelerating basis characterized by increasing aggregate private credit and rising leverage ratios applied to collateral assets. The accelerating credit formation applied to tangible collateral assets increases the price of those assets and drives a dynamic increase in leverage ratios used to lend on those assets. This leverage driven, credit formation driven, increase in assets value expands to increase the the general price of all goods and services as aggregate credit expands. The expansion of aggregate private credit is the 'velocity' variable that economists struggle with. Its not about how fast money changes hands, its about the rate at which private credit is expanding...if it is expanding rapidly and accelerating then money is changing hands quickly and the price of all goods and services will go up in an inflation.

    The same is true in reverse, when collateral assets are not increasing in value, where credit extended on collateral assets begins to default and the value of the collateral is challenged, leverage ratios begin to decline and the value of collateral assets begin to decline. Defaults increase and private credit contracts. This is deleveraging which is deflationary. Capital flows out of tangible collateral assets and into short term liquidity accounts, money and money substitutes, as the capital coming out of inflated tangilbe assets builds up in liquidity accounts it does not drive investment in assets and ends up in excess reserves.

    Inflation is capital flowing into collaterial assets as private credit expands and leverage ratios increase.

    Deflation is capital flowing out of collateral assets a private cedit contracts and leverage ratios decrease.

    That is how it works in a fiat money system. It works differently in a gold based system.
  7. Whizo


    Found this article that touches on the ex food and energy issue.

    In a and energy comprises approx 22-25% of the average household budget, yet neither of these items are included.

    Total scam.

    There is no other way to describe it.

    Ask anyone if their fuel bill or grocery bill is only 2-3% more expensive.

    Total scam.
  8. Ed Breen

    Ed Breen

    Whizo the point is what the CPI or the PCE is really used for. Its most important use is to inform monetary policy as a very gross and imprefect measure of the monetary effect of inflation. For that purpose, as I said above the Fed uses the Core PCE. The idea that it is supposed to measure the change in the price of stuff that Whizo buys is simply not the case. The idea that the CPI is designed or should be designed to mirror the costs of the everyday person is simply not the case. Who is the everyday person any way...Someone who has diabetes and three kids in high school who expect to attend private university? A farmer with two kids in Minnesota? A couple in their 80's living in a house they paid for in upstate New York? A er, single, just moved to Greenwich village from Palo Alto, not comfortable with the subway yet? What index can measure the cost change that is relevant to each of these lives? If you look into the detail of these indexes you can find those sectors that each of thies cases would be weighted to.

    The point of the inflation index is for the Fed to use the inflation index to create price stability through competent monetary policy...or at least, slow or predictible change over time. Its not supposed to reflect the cost of what Whizo, or everyman, is buying.

    Having said that, the idea that congress adjusts social security according to CPI and would argue for a change to the 'Chained' CPI' as a social security reform is complete garbage. If you wanted the social security benefit to mirror the cost of living of people at the age where they qualify for social security you would build a completely different index. If you want to reduce what you are paying them you should just say that you will reduce what you are paying or use a means test or raise the age for benefits...but to torture a tortured index so the voters get even more confused about how they are being defaulted on is dysfunctional and close to evil. The real problem with the index is that people try to use it in ways it should not be used.

    Other than that, it is inaccurate enough for its proper purpose. Its more a complication of mistakes and misunderstanding than it is a 'sham.'

    If you really want to get into a confused mess of wrong thinking passing as conventional wisdom you should ask about whether the GDP measures growth or reflects wealth.
    #10     Mar 1, 2013