23 Dec

Why Reported Inflation Seems Different Than Reality

Lance Roberts @ Zero Hedge:

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:

“…the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third.”

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.

“That new washing machine you bought did not cost you 20% more than it would have cost you last year, because you got an offsetting 20% increase in the pleasure you derive from pushing its new electronic control buttons instead of turning that old noisy dial, according to the BLS.

When gasoline rises 10 cents per gallon because of a federally mandated gasoline additive, the increased gasoline cost does not contribute to inflation. Instead, the 10 cents is eliminated from the CPI because of the offsetting hedonic thrills the consumer gets from breathing cleaner air. The same principle applies to federally mandated safety features in automobiles. I have not attempted to quantify the effects of questionable quality adjustments to the CPI, but they are substantial.”

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.

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About Curt

Curt served in the Marine Corps for four years and has been a law enforcement officer in Los Angeles for the last 20 years.

One Response to Why Reported Inflation Seems Different Than Reality

  1. DaNang67 says: 1

    Inflation is the solution to all our fiscal problems.

    Inflation will reflect in stock prices and make it seem as if the market is actually rising as retiring boomers are selling stocks to live on their IRAs and 401-Ks. This will lessen the pressure on underfunded public sector pensions.

    Inflation will increase housing prices and home values so that homeowners can use their home equity to support their credit card dependence. Thus the banking industry will thrive.

    Inflation will allow us to pay our immense debt with plentiful cheapened dollars.

    Inflation will eventually reflect in wages so that the productive class can survive and be placated.

    The only harm done by inflation is done to people on fixed incomes which rise only in accord with the government-controlled official rate. These are primarily Social Security recipients and everyone hates them for their greed.

    ReplyReply

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