Originally Published: 6/4/2008
INFLATION and THE CPI
By The Issue Wonk
We all know what inflation is: our costs go up. The formal definition, from Wikipedia, is: A rise in general level of prices of goods and services over time. Moderate inflation is generally believed to be caused by an increase in demand or a decrease in supply, or both. Most economists believe that high rates of inflation are caused by high rates of growth of the money supply. (See Monetary Policy.) There are reasons for calculating inflation other than just to figure out why our wallets are lighter. Phillips points out that “inflation measurements help determine interest rates, federal interest payments on the national debt, and cost-of-living increases for wages, pensions, and Social Security benefits.”1 Do you think your costs are going up more than the official inflation rate? (See a table of the monthly and annual inflation rates from 2000.) So do I.
The Consumer Price Index
The U.S. Bureau of Labor Statistics calculates the inflation rate for the country. In order to do this, it uses the Consumer Price Index (CPI). The CPI is a number that averages the price of consumer goods and services purchased by U.S. households. The percent change in the CPI is the inflation number that they report.
I’m not going to go into detail about how the CPI is calculated. It’s an extensive statistical calculation. But, in short, there are 2 types of data used: price data and weighting data. According to Wikipedia, “The price data are collected for a sample of goods and services from a sample of sales outlets in a sample of locations for a sample of times.” Since all goods and services cannot be treated the same, they “weight” the data, an estimate of how much each good or service would appear as a fraction of the total expenditure. For example, people buy more chicken than caviar so chicken will have a greater weight than caviar. Here are the weights given to the various factors for the December 2007 calculation for “the average American city.” (If you want more information, Wikipedia has a good description.) To complicate things further, CPIs are calculated for urban and rural regions and for different regions of the United States. The CPI-U, calculated for urban consumers only, is the most frequently quoted.
Sounds complicated but straightforward, doesn’t it? Not quite. All these variables can and are manipulated. According to Phillips:2
. . . the federal minimalization and misrepresentation of inflation, pursued statistically over the last 25 years, has been the main buttress of Washington’s over-favorable and self-serving portraiture of the U.S. economy.
That something is being manipulated shouldn’t surprise anyone. We all know that the cost of gasoline is up about 80% over last year. Groceries are up about 40%. In many cases, health insurance is up more than 35%, and has gone up 25%-35% each year since 2001. So, how do they come up with the inflation rates we’ve been seeing of 2%-3% annually?
Manipulation of CPI
According to Phillips,1 manipulation of the CPI began with President Richard Nixon, who “created a division between ‘core’ inflation and headline inflation. If the Consumer Price Index was calculated by tracking a bundle of prices, so-called core inflation would simply exclude, because of ‘volatility,’ categories that happened to be troublesome (and thus in the ‘headlines’).” [Emphasis added.] At that time, “troublesome categories” were food and energy. Things haven’t changed much, have they? So, when you hear “core” inflation being reported, you’ll know it doesn’t include food and energy.
President Ronald Reagan decided that housing was overstating the CPI and “substituted an entirely different ‘Owner Equivalent Rent’ measurement, based on what a homeowner might get for renting his house. This methodology, controversial at the time but still used, sidestepped what was happening in the real world of homeowner costs. Some say that led to the mortgage crisis today.”1 [Emphasis added.] This manipulation of the CPI calculation reduced the inflation rate by 3% to 4%.
President George H.W. Bush wanted to take the CPI away from industrial-era methodologies and have it include the services economy and the expanding retail and financial markets. “Skeptics said the underlying goal was to reduce the inflation rate in order to reduce federal payments – from interest on the national debt to cost-of-living outlays for government employees, retirees and Social Security recipients.” Bush set up the new methodology but it was President Bill Clinton who implemented it. Clinton, however, took it further by reducing the monthly household economic sampling, disproportionately eliminating inner city households.”1 [Emphasis added.] This manipulation reduced the inflation rate by another 1%.
In 2002 President George W. Bush introduced an “experimental” CPI calculation – the C-CPI-U – “which shaved another 0.3% off the official CPI; and since 2006 it has stopped publishing the M-3 money supply numbers,3 which captured rising inflationary impetus from bank credit activity.”1
Moreover, since the 1990s, the CPI has been subject to 3 other adjustments, all downward and all dubious product substitution. (If flank steak gets too expensive, people are assumed to shift to hamburger, but nobody is assumed to move up to filet mignon), geometric weighting (goods and services in which costs are rising most rapidly get a lower weighting for a presumed reduction in consumption), and, most bizarrely, hedonic adjustment, an unusual computation by which additional quality is attributed to a product or service.1
Hedonistic Adjustments. Hedonistic adjustments are used to reduce the effective cost of goods, which reduces the stated rate of inflation. Here are some examples. Let’s say that last year you looked at buying a new refrigerator, but didn’t buy it. This year you bought it, but it cost 20% more than last year. Hedonics holds that you aren’t really paying 20% more because there are up-grades (like fancy buttons or a different storage array on the door) that increase your pleasure by 20%. Or, when gasoline prices increase because of federally-mandated additives, you’re not really paying more because you’re getting cleaner air. These types of increased costs are not included in the CPI.
Intervention Analysis. Intervention analysis is applied particularly to a commodity, like gasoline, that is going through immense changes. Intervention analysis makes the inflation not so volatile. So, rising gas prices aren’t fully reflected in the CPI, but declining prices are.
Weighting. Yeah. We’re back to that. Since the CPI measures out-of-pocket expenses, items are weighted by adding or subtracting from a base of 1.00. In a nutshell, the more of something a consumer uses, the greater the weight, making the weighted score greater than 1.0. However, it’s assumed that if the price goes too high, people will stop using it or use less of it, giving it a weight of less than 1.0. Look at the 2007 CPI-U. Health insurance is given a weight of .477, meaning that it’s getting so high that fewer people have it, and lowering the overall CPI. Prescription drugs are given a weight of .998, meaning they assume that as the cost of prescriptions rise, people will purchase fewer prescriptions. However, gasoline is given a weight of 6.940, meaning people will pay whatever they have to and continue to consume. As you can see, all these assumptions have a direct effect on the overall calculation of the CPI and, thus, the reported inflation rates.
What do all these adjustments mean to consumers? Here’s the perfect example. “If you were to peel back changes that were made in the CPI going back to the Carter years, you’d see that the CPI would now be 3.5% or 4% higher” meaning that, “because of lost CPI increases, Social Security checks would be 70% greater than they currently are.”1
Adding energy and food to the reported “core” inflation rate and adjusting for all the prior manipulations, the current inflation rate would be about 10%.1 Just imagine what that would do to interest rates. Now, try to imagine what the U.S. debt service on our almost $3 trillion debt would be. In FFY 2007, at the lower interest rate, we paid $238 billion net interest.
Who are the winners of this manipulation? The person sitting in the White House looks real good as it appears that inflation is low. The U.S. government makes out real well because debt service payments are considerably lower and Social Security and pension payments are kept low. And “many businesses and financial institutions have been winners.”1 Taxpayers could also be winners since they are the ones who’d have to pay for all the government’s increased spending. However, they are still the losers with lower Social Security payments, pension payments, salary increases, and interest on savings.
1 Phillips, Kevin. Hard Numbers: The Economy is Worse Than You Know. Harper’s Magazine, April 27, 2008. (preserved at Tampabay.com)
2 Phillips, Kevin P. Washington’s Great “No Inflation” Hoax. Huffington Post, May 8, 2008.
3 M-3 is the broadest measurement of the amount of money in the economy. It is tracked in order to monitor the growth of the money supply. (Wikipedia)
© The Issue Wonk, 2008