That’s not inflation, you only *think* it’s inflation
By: David A. Smith
What is inflation?, asked jesting Descartes, and would not stay for answers.
What makes you think this is a blot?
In politics, perception is reality, so what happens is less important than what the vast bulk of people perceive to be reality. For most of us, inflation is not what we experience weekly at the gas station or the grocery store, but rather, what some newscaster announces it to be – and what if those announcements are skewed, as suggested by two articles, one from the Wall Street Journal (Arial), the other from CNBC (Calibri)
Inflation Actually Near 10% Using Older Measure
It may surprise you to learn that we still have no absolute method for calculating inflation. Different statisticians use different methodologies, and from time to time the mix is changed, always on the grounds of ‘greater accuracy’ but often with significant consequences:
I wasn’t appointed to be liked
After former Federal Reserve Chairman Paul Volcker was appointed in 1979, the consumer price index surged into the double digits, causing the now revered Fed Chief to double the benchmark interest rate in order to break the back of inflation.
I can well remember that at the time people hated Volcker, because he drove interest rates up to the high teens, crushing commercial real estate values:
Try buying a house with a 19% Fed funds rate …
Of course, our current situation is nothing like that – at all:
Using the methodology in place at that time puts the CPI back near those levels. [Under those formulae,] inflation hit an annual rate of 9.6% in February, according to the Shadow Government Statistics newsletter.
The differences are substantial, and structural, as demonstrated by the chart below.
Which line do you believe?
What then is the reason for changing the computation of inflation?
Since 1980, the Bureau of Labor Statistics has changed the way it calculates the CPI in order to account for the substitution of products, improvements in quality (i.e. iPad 2 costing the same as original iPad) and other things.
Backing out more methods implemented in 1990 by the BLS still puts inflation at a 5.5% rate and getting worse, according to the calculations by the newsletter’s web site, Shadowstats.com.
These variances – 2.6% from the BLS, 9.6% from the subscription-hawking SGS site – are large enough to warrant delving more deeply into the methodologies:
Shelter costs account for 32% of the overall consumer-price index and about 40% of core CPI, which excludes volatile food and energy.
Hold on a moment, says the Careful Shopper. What kind of inflation measure excludes food and energy?
A boy’s gotta eat, doesn’t he?
For those who take issue with excluding food and energy, the Cleveland Fed has a “trimmed mean” CPI that strips out the 8% of items with the largest price increases and the 8% with the biggest declines.
I’m sure someone thought that eliminating these outliers would yield a more stable month by month shift in inflation rates, but suppose that some commodities are really increasing rapidly, and continuously – like, say, gas?
Don’t like the trend line here
It rose 1.2% year-on-year in February. There is also a median CPI, showing the price change of the item whose monthly move falls smack in the middle of the pack—up 1% as of February.
By now you realize that your measure of inflation is a Rorschach blot of what you think is important.
“While the federal government would have us believe the numbers are rather tame, our own personal gauge leads us to believe inflation is running between 5% to 6% annually,” wrote Alan Newman in his latest Crosscurrents newsletter that refers to Williams’ statistics.
Housing fits into the inflation calculations, given that everybody sleeps somewhere, and nearly everybody pays for housing, either in rent or in the costs of mortgage financing:
The tightening rental market, as fewer Americans opt to buy homes, is a key reason why core inflation stopped declining last year and is moving higher.
Are these the right commodities to measure?
Rental drives inflation, and quite possibly may drive CPI more than home prices do, even though home mortgage interest rates powerfully influence the economy. The BLS solves this in an economically logical but mathematically curious way:
The biggest component of shelter is so-called “owners’ equivalent rent,” which is an approximation of what homeowners would pay to rent their property.
Already we are dealing with an abstraction. I won’t recapitulate the BLS’s algorithm – it’s clearly laid out here – and instead will rely on the Journal’s summary:
The measure is calculated using rental increases and doesn’t factor in changes in house prices or mortgage payments, even though most people in the US own their homes.
Thus, even though roughly two out of three American households are homeowners, inflation is computed on the assumption that everyone’s occupancy costs rise and fall as if they were rentals. This isn’t a horrible theory – indeed, it’s hard to think quickly of one that would be unambiguously better – yet it is by definition an abstraction.
Some suggest alternative inflation measures. A “supercore” alternative excludes not just food and energy but shelter, too, to gauge underlying trends.
Actually, if you exclude everything normal people buy, eventually you’ll derive an inflation low enough to be politically palatable. Of course, you’ll have to leave reality behind:
Yet this would hardly sit well with most Americans, who already feel the Fed is ignoring the runup in food and energy costs and know housing is a huge cost.
The Federal government needs to adopt Bill Simmons’ Vice President for Common Sense.
If common sense is the only qualification, I’m available!
The Fed’s own preferred gauge is the price index for personal consumption expenditures, or PCE, which is based on actual monthly outlays instead of the CPI’s household survey.
Inflation indices involve judgment in two dimensions: first how one chooses to observe the prices being measured, and second by how they are weighted to combine into an average:
The PCE gives a higher weight to medical costs than the CPI and a lower weight to housing—15% of headline PCE and 17.5% of core. It is also why the core PCE, as of February, was up only 0.9% year-on-year.
Instead of using abstruse approaches, one can also take a market-power approach:
Newman uses recent comments from Wal-Mart CEO Bill Simon that inflation is going to be “serious” to back up the much higher CPI figures from him and Williams.
“Maybe this big, maybe even bigger”
“Given Walmart’s sales of $422 billion, we think Mr. Simon has a good idea of what’s in the pipeline,” said Newman.
To be sure, the BLS argues that the changes it has made over the last three decades more accurately reflect a true change in the cost of living.
That’s a nullity: no one who changes rules claims to be making them less accurate … but less accurate they can nevertheless become.
For example, in response to its hedonic adjustments, the BLS web site states, “to measure price change accurately, the CPI must be able to distinguish the portion of price change due to this quality change.”
‘Hedonic’ being a ten-dollar word for ‘on the fly’ [Actually, it means 'when adjusted for changes in quality – Ed.], the BLS must add to its selection and weighting adjustments a host of further adjustments for changing quality standards and consumer demand.
Economist agree, no two economists can agree
By now it should be clear that there are dozens if not hundreds of defensible ways to estimate inflation. What should matter is picking one and sticking with it, or at the very least always computing the historical metrics alongside the current ones. Otherwise the confirmation bias will lead you to bleed into your new inflation calculations whatever will make you feel better.
Still, going by recent strong comments from Federal Reserve officials, even members of the central bank must believe inflation is being underreported. Dallas Federal Reserve President Richard Fisher said in a speech last week that the central bank was reaching a “tipping point” as far as changing its policy so it can react to inflation.
Another chart: not just the officially unemployed, but also those underemployed or labor force dropouts
Low rates are allowing those who are employed to raise prices, and before you know it, inflation will be rising and that will be the next great US macroeconomic problem.
“The need to break the back of that (budgetary debt) spiral is as dire now as was the need for Paul Volcker to break the back of inflation in the 1980s,” said Fisher on April 8th. “As a result of his steadfast determination to press on with exorcising inflation, Mr. Volcker is today among the most respected living Americans and widely considered an exemplar for public servants worldwide.”
He got that respectability through the Noah Cross approach, being old.
The boost to inflation this year may be partly due to a quirk of the housing market, but the upward pressure will nevertheless be difficult for the Fed to ignore.
CPI drives perceptions and politics; it also drives Cost-of-Living Adjustments (COLAs), and many government and public-pension-fund legal obligations.
All these COLAs rise with inflation
Even more importantly, our standardized estimate of inflation, the Consumer Price Index, is written into contacts and laws, so if it is flawed (as HUD’s Fair Market Rent was flawed for decades), then the US pays less than it legally otherwise would.
For a government massively in debt, with no coherent plan whatsoever for balancing its budget, the ideal would be to have high inflation (which deflates our fixed-dollar obligations) but not admit to high inflation.
Which is precisely what our current CPI does.
Inflation is already here.