Why Reported Inflation Seems Different Than Reality

Discussion in 'Politics & Religion' started by Tsing Tao, Dec 20, 2012.

  1. Tsing Tao

    Tsing Tao

    Bookmark this post. The next time some Keynesian refers to the CPI being tame, feel free to point them here.

    Lance Roberts of StreeTalkLive

    The subject of inflation has remained an emotionally charged topic of debate over the last several years. As rising prices for individuals, and businesses, has negatively impacted their prosperity; reported inflation has remained at very low levels. With the Fed pumping trillions of dollars into financial system the fear of much higher inflation, as the dollar is debased, has caused gold prices to soar in recent years. As we will discuss momentarily, the issues surrounding government spending, and the massive deficit, has brought the topic of inflation to the forefront of the political debate.

    However, a bit of history is needed for context. The government produces a measure of inflation called the consumer price index (CPI) which is generally broken down into two reports: Headline and Core. The only difference between the two measures is that the core reading strips out the volatile food and energy components. It is this core reading that economists, and the Fed, focus on much to the aggravation of average consumers who quickly point to the fact the food and energy are big part of their daily lives.

    The sole purpose in measuring inflation is to help businesses, individuals and government adjust their financial planning for the impact of inflation. Inflation erodes future purchasing power, and decreases economic prosperity, if not accurately accounted for. The accuracy of measuring inflation, and accounting for it properly, is essential to long term economic prosperity.

    The original calculation of CPI, which measured the change in the cost of an identical fixed basket of goods priced at prevailing market costs each period, worked reasonably well for the intended purpose into the early-1980’s. However, as the pressure of increasing deficits weighed on political parties, the need to find solutions to reducing spending, without actually cutting spending, led to several substantial changes in the calculation of inflation.

    Shortly after Clinton entered the White House the Bureau of Labor Statistics (BLS) altered the calculation of inflation by changing the weighting of goods in the CPI fixed basket. Then, over subsequent years, the method of weighting the underlying components was changed from a straight arithmetic weighting method to geometric. The primary result of the switch to a geometric weighting was a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price which led to lower reported inflation.

    According to John Williams

    But the manipulation of the data did not stop there. Aside from the weighting changes the BLS instituted a system of “hedonic” adjustments. Hedonics adjusts the prices of goods for the increased pleasure the consumer derives from them.

    Lastly, there is "intervention analysis" in the seasonal adjustment process. Intervention analysis is critical to the highly volatile areas of food and energy. When a commodity, like gasoline, goes through periods of violent price swings the BLS steps in and uses “intervention analysis” to smooth out the volatility. As a result, sharply rising gasoline prices are never fully reflected in the reported headline inflation number. However, declining prices, which are never adjusted, do show an impact to reducing inflation.

    The obvious problem with these manipulations is it changed the measure of inflation from a cost-of-living adjustment to a reduction-of-living adjustment. The original CPI calculation allowed individuals to understand the rate of return required on investments and incomes to maintain their current standard of living. However, by artificially suppressing the rate of inflation, the future standard of living is reduced to lower levels.


    The chart above shows the original calculation of inflation (which was based on a basket of goods), data sourced from John Williams, versus the current measure of CPI. It is quite apparent that inflation, as reported by the Consumer Price Index (CPI), is understated by roughly 7% per year.

    The deviation between the two measures is strictly due to the redefinitions of the series and adjustments to price measures utilized. These changes to the CPI have detached the cost-of-living adjustments from the real cost-of-living experienced by those dependent upon a fixed income stream for survival.

    According to John Williams:

    This is why the average American has repeatedly lashed out at the current measure of inflation as it doesn't represent the inflation rate that they are personally experiencing. Rising food and energy costs are consuming more and more of a declining level of incomes. For those individuals dependent on a fixed stream of welfare payments the lower rate of inflation adjustments, while putting more money in the coffers of the government, has led to a steadily declining standard of living for the elderly.


    The Chained CPI “Fiscal Cliff” Farce

    In the latest attempt to save the economy from the "fiscal cliff" a grand bargain is being crafted that will possibly include a relic from the debt ceiling debate in 2011 called "Chained CPI." As with the Clinton Administration, once again the need to reduce government spending has given rise to a proposal to further suppress the measure of inflation to reduce the cost of living adjustments for social security recipients. The issue with "Chained CPI,” as with the current measure of CPI, is that it will further misrepresent what the average consumer is living with from day to day.

    The Washington Post stated:

  2. Tsing Tao

    Tsing Tao

    (cont'd from above)...

    When it is known in advance that tweaking the math will create a "permanent" reduction in the measure of inflation then it is no longer an accurate assessment of inflationary pressures in the economy. If adopted across the government, the change would have far-reaching effects on the many programs that are adjusted each year based on year-to-year changes in consumer prices.

    The groundswell of aging “boomers” that will are rapidly approaching the point of become welfare program recipients will find that the fixed stream of income payments will not be sufficient to maintain their current standard of living in the future. This will continue to push an ever aging population into working much longer into their retirement years.

    Furthermore, a side effect of artificially suppressing inflation is that taxes would slowly increase because annual adjustments to income tax brackets would be smaller. This would eventually push more people into higher tax brackets allowing fewer people to be eligible for anti-poverty programs like Medicaid, food stamps and school lunches. While the annual adjustments will eventually remove individuals from poverty on a statistical basis – it doesn’t mean that would be any more capable of supporting themselves.

    Lastly, one reason why there has been such a disconnect between reported GDP, and the way that average Americans feel about the economy, is due to the way CPI affects the GDP calculation. Although the CPI is not used in the actual GDP calculation, there are relationships with the price deflators used in converting GDP data and growth to inflation-adjusted numbers. The more inflation is understated, the higher the inflation-adjusted rate of GDP growth that gets reported. The problem is that real inflationary pricing pressures is simultaneously eroding the real prosperity of the average consumer.

    While going to "Chained CPI" will save the government over $100 billion during the next decade in payments to individuals - this is not a good thing for those dependent upon those payments. Furthermore, the assumptions for budgeting will also be grossly flawed which means that when we get to the end of this decade it is likely that we will be in worse shape than was estimated. Hopefully, those in Congress will opt not to further suppress the inflation calculation for political gain at the expense of the average American.

    In the coming weeks ahead, in collaboration with my friend Doug Short, we will be introducing an inflation index which will be reconstructed along the same lines as the original form of CPI using an arithmetically weighted calculation on a fixed basket of goods. It is hoped that from this experiment we can establish a baseline from which we may be able to ascertain the actual impact of the current environment on incomes, spending and the economy. Stay tuned.
  3. BSAM


    Brother Tao, if you have a job, how is it you have time to post on the internet all day?
    I mean, I tend to believe that you do, but like, does your boss know what you do all day?
    Aren't you a financial director for some big food outfit?
  4. jem


    excellent post
  5. Tsing Tao

    Tsing Tao

    Yes to all your questions. I do not post this frequently all the time. There are groups of days where I go without posting because I simply don't have any time at all. But as I alluded to once today, it is really slow before the holidays. The entire office is still pigging out from all the food from the Christmas party. I have done my type of job for most of my career. The work is typical - some days 14 hours long with a rush for close. Some days with naught but an hour or two. You do see that my average is 4.44 posts per day, right?

    And thank you once again for offering nothing to the thread discussion, but trying to sidetrack instead.
  6. BSAM


    No need to be a wise ass.
    Of course, knowing you hate your mother, I can only imagine how you must feel about me.
    Have a nice afternoon.
  7. Tsing Tao

    Tsing Tao

    I give you honest answers to questions you ask. You are a consistent prick to me, and then you get mad and upset when I respond accordingly. What a shock.
  8. BSAM


    I'm not mad.
    Yes, I am.
    You've hurt me so that this is my last post on ET.
  9. Tsing Tao

    Tsing Tao

    If only that were true.
  10. BSAM


    (Peeping around the ET corner, snickering loudly...hoping Tao doesn't hear me...)

    #10     Dec 20, 2012