The Real Rate of Inflation
In the most recent report by the Bureau of Labor Statistics (BLS), the Consumer Price Index (CPI-U) recorded a 2.9 percent year-over-year increase in the 12 months ending in February[i]. The CPI-U is widely regarded as a broad measure of inflation and is used in calculating the cost of living adjustments for many wage-based contracts, including Social Security. Along with the CPI-U, the Core CPI-U is also frequently quoted in various publications. The Core CPI-U, which eliminates the volatile food and energy sectors, rose by 2.3 percent year-over-year[ii]. The Federal Reserve tracks this number closely because a majority of its members believe that this more adequately reflects the effects of their actions through the increase or decrease in the money supply. In contrast, many Fed members believe that food and energy prices are a function of global supply and demand and cannot be altered through their actions. Moreover, the Fed attempts to keep core inflation at approximately 2 percent. Despite these relatively modest numbers there seems to be a widespread perception of higher inflation among the public. Could it be that the Northeast has a higher rate of inflation than the rest of the country? [iii]
According to the adjacent chart, in the Northeast Core CPI increased 2.4 percent – slightly higher than the national figure – and headline inflation increased 2.8 percent which was less than the 2.9 percent increase nationwide. Although inflation was lower in the Northeast compared to the rest of the country, the difference between the two was miniscule. This suggests that the perception of higher inflation is not a product of the region of the country. Instead, the answer lies in the way the Consumer Price Index is calculated. Consumers can point to the relatively new model for calculating the CPI that incorporates the ideas of substitution and hedonics for the understated rate of inflation that the CPI produces.
The Need for Change?
The CPI-U measures the “average change over time in the prices paid by urban consumers for a market basket of goods and services.”[iv] According to the Bureau of Labor Statistics, this group represents about 87 percent of the US population. For the current CPI, the market basket of consumer goods was constructed from information collected by the Consumers Expenditures Survey from 7000 families during 2007 and 2008. The CPI-U consists of several categories: food and beverages (14.79 percent), housing (41.46 percent including rent which is 31.5 percent of the CPI-U), apparel (3.60 percent), transportation (17.31 percent), medical care (6.63 percent), recreation (6.29 percent), education and communication (6.42 percent), and other goods and services which include cigarettes, haircuts, dry cleaning, etc. (3.50 percent)[v]. Initially, the BLS created the Consumer Price Index in response to the increase in prices, especially in shipbuilding, during World War I which created a necessity for a cost-of-living index in order to adjust wages in union contracts. Starting in 1921, the BLS published annual CPI numbers. Over time, especially after WWII, the CPI began to be used more often for cost-of-living adjustments in labor contracts. Another popular use for the CPI was in determining the cost-of-living adjustment for Social Security recipients after legislation enacted in 1973 provided that payments to recipients keep up with inflation. According to economist Walter Williams, this made the CPI susceptible to political influence[vi]. During the early 1990s, a movement led by Michael Boskin, then chief economist to the first Bush Administration, and Alan Greenspan, the Federal Reserve Chairman, argued that the CPI was overstating inflation. In 1995 the US Senate appointed the Boskin Commission to study possible bias in the calculation of the Consumer Price Index. It concluded that the CPI overstated inflation by 1.1 percentage points per year prior to 1996[vii]. The report based this conclusion on possible biases: a substitution bias that failed to accurately reflect the fact that consumers substitute for cheaper goods when some goods become more expensive; a quality change bias in which improvements in products are not measured in prices; and a new product bias in which new products that are less expensive and more efficient are not included in the basket of goods that are measured. Although Congress did not mandate a change in the CPI, the BLS began to implement changes that were brought into focus by the Boskin/Greenspan movement. Initially, the CPI was measured using the costs of a fixed basket of goods. Yet, the Boskin movement argued that if certain products, such as steak or wine, became too expensive, consumers would choose to buy cheaper goods, such as hamburger or beer. Therefore, the CPI basket of goods should take into account this substitution. Also, the Boskin/Greenspan argument focused on the need to accurately measure the change in quality of a product. For example, if a computer increased in power and efficiently over the course of a year but remained the same price, the index should instead lower the price of the good in the basket in order to measure the increased benefit that a person received from using the updated product. [viii]
The Silent Substitution
“The debate about the CPI was really a political debate about how, and by how much, to cut real entitlements.”
-Greg Mankiw, chairman of George W. Bush’s Council of Economic Advisers from 2001-2003[ix]
In the early 1990s, the Clinton Administration began to study ways to ensure the solvency of the Social Security system. By forecasting the effect of the retirement of the baby boomer generation within the next thirty years, the Clinton Administration deduced that steps needed to be taking to improve the finances of the Social Security Trust Fund. Furthermore, the federal government wanted to decrease its expenses in order to narrow the budget deficit that had expanded in the late 1980s. Possible changes included raising the age for Social Security eligibility, increasing the payroll tax, or decreasing the amount given to current and future recipients. As is still the case, suggestions on reforming Social Security drew an uproar. As a result the Clinton Administration eased off the notion that Social Security needed to be reformed. Yet, this did not stop the BLS from tweaking the formula for calculating the CPI. Over the following years beginning in 1999, the BLS began to use geometric weighting instead of arithmetic weighting[x]. This means that it gave a lower weighting to CPI components that were rising in price and a higher weighting to those items that were decreasing in price. For example, if the price of filet mignon increased and the price of flank steak decreased, the weighting for filet mignon would automatically decrease and the weighting for flank steak would automatically increase. Because both filet mignon and flank steak were in the same subsection of the ground beef component, the creators of the geometric weighting conceived that it was likely that consumers substituting flank steak for filet mignon. In many cases the geometric weighting involved trading down from a higher quality to a lower quality good. Although the BLS attempted to contradict this belief by stating that the “CPI’s objective [was] to calculate the change in the amount consumers need[ed] to spend to maintain a constant level of satisfaction,” the shift from a fixed basket to the variable basket through the use of geometric weighting amounted to a change for consumers towards lower quality goods.[xi] The BLS calculated that the shift to geometric pricing lowered the annual growth rate of the CPI by 0.3 percent, but other economists have calculated that it underestimated inflation by approximately 3.0 percent annually.
While the use of substitution through geometric weighting was one way in which the CPI was lowered – and the government did not have to send out as much money to Social Security recipients – the use of hedonics was another way in which the CPI formula changed.
“Hedonics” is derived from ancient Greek and means “pleasure doctrine.”[xiii] Through the use of hedonics, the BLS can attempt to quantify the quality of a good in price-indexing. If the price of a good increased over the year but the BLS determined that the increase in quality was greater, then the price of the good in the CPI formula would actually decrease. Although the BLS’ intent was to provide an objective index, the use of hedonics guaranteed that the index was partly subjective. With the company and technicians of the product happy to demonstrate ways in which the product has improved, this places pressure on the BLS official to incorporate a higher rating for quality in the price model for the product. With approximately 50 percent of the CPI comprised of products subject to hedonic adjustments, the BLS judgments on quality could significantly alter the inflation rate. As demonstrated by this graph, Pacific Investment Management Corporation (PIMCO) estimated that the Personal Consumption Expenditures Index – an inflation index similar to the CPI – was underestimated by 0.5-1.1 percent per year because of the use of hedonics and substitution. In a 2004 Economics and Portfolio Strategy piece, Peter Bernstein points out that from 1990-2004 total CPI inflation was 2.7 percent per year, but hedonically adjusted goods only increased by 0.1 percent per year. Finally, PIMCO’s manager, Bill Gross, made this point: “If you substitute a pound of chicken for a pound of beef because it’s cheaper, then switch back to beef later on because it came back down in price, the overall round trip which resulted in no ultimate substitution and no relative price change winds up reducing the stated PCE.”[xiv]
History Repeats Itself
One of the deficit-cutting measures currently under consideration is to start using the BLS’ Chained Consumer Price Index (C-CPI-U) to index Social Security benefits and tax brackets. The Chained Index assumes that, for example, if the price of filet mignon rises, then people do not have to buy another type of ground beef such as flank steak, but can instead buy another form of food, such as chicken. Theoretically, a person could substitute eating white rice for beef. In turn, the price that he or she spends on food would decrease, but his or her standard of living would also decrease. While the chained-index does not take substitution to this extreme extent, this example demonstrates the problems inherent in substitution. In comparison to the CPI-U, the Chained Index calculates a lower average inflation rate.
By using the C-CPI-U the Social Security Fund would remain solvent over a longer period of time. However, this would be to the disadvantage of future beneficiaries of the fund. Moreover, seniors consume more healthcare than the average person. With healthcare costs having rose 6.4 percent annually over the past decade, CPI-U already inadequately represents the rising annual costs for seniors. Consequently, as was the early 1990s, today’s index changes will be a direct result of the government’s desire to slowly lower the amount that each person receives in Social Security.
The CPI-U, and related indexes, plays an important role in other economic statistics. In order calculate productivity, real GDP, and real investment, a price deflator is needed and that deflator is derived from the price index. If the inflation rate is low, then productivity, real GDP, and real investment will all be higher, and vice versa. Therefore, the government benefits in two ways if inflation remains low: it will have to pay less in Social Security and real GDP numbers will be higher. With these incentives, government officials probably justify these index formula changes as necessary adjustments with today’s demographics and economy. In the meantime, if you find yourself wondering why inflation feels higher than the CPI numbers that are reported, it’s because inflation is higher. With “real” inflation at approximately 4-4.5 percent over the past year, it’s understandable why many people feel that their budgets are pinched. In order to maintain purchasing power in the future, one should focus on obtaining returns that are at least equivalent to this “real” inflation. Since even 30-year Treasury bonds currently yield less than 3.5 percent, it would probably be wise to avoid US government bonds, especially those with long term durations[xvi]. Similarly, many investment grade bonds have increased significantly in value over the past year leaving an unfavorable risk-return trade off for new investors. Savers are left with investing in foreign government or investment grade bonds, Treasury Inflation Protected Securities (TIPS), or equities. In foreign government bonds, sharp divisions currently exist: developed countries with moderate fiscal situations, low interest rates, and low yielding bonds, developed countries with poor fiscal situations and high yielding bonds, and developing countries with fast growing economies but still relatively small public bond markets. Except for a few countries, such as Australia, we are hesitant to recommend that anyone dive headfirst into foreign government bonds right now. Next, TIPS provide a hedge against inflation as measured by the CPI-U because an investor’s semiannual payments are adjusted based on the level of inflation that the BLS calculates. Yet, TIPS do not provide protection against any underestimation in the calculation of the CPI-U. Finally, equities have historically provided the best hedge against inflation because they have averaged a return of approximately 7-8 percent over the past 100 years. Over the long term, equities probably should continue to have the highest inflation-adjusted returns. Stocks are claims on real assets, such as plants and equipment, which appreciate as overall prices increase.[xvii] Furthermore, over the long run companies have shown the ability to pass along increased expense costs to consumers. Also, investors should consider international equities. If inflation increases domestically, the dollar will decline relative to foreign currencies causing money invested in foreign currencies (companies) to be worth more when translated into dollars. Consequently, a diversified portfolio of domestic and international stocks probably remains the best long term hedge against high US inflation.
Disclosure: The opinions and forecasts expressed are those of the representative, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or investment plan. The representative does not guarantee the accuracy and completeness, nor assume liability for loss that may result from the reliance by any person upon such information or opinions. Past performance does not guarantee future results."
[iv] Consumer Price Index. 19 Oct 2011. Bureau of Labor Statistics
[vi] Williams, Walter John. Government Economic Reports: Things You’ve Suspected but Were too Afraid to Ask!” 1 Oct 2006. Shadow Government Statistics. 15 Dec 2011. <http://www.shadowstats.com/article/consumer_price_index.>
[vii] The Boskin Commission Report. 4 Dec 1996. Social Security Administration. 15 Dec 2011. <http://www.ssa.gov/history/reports/boskinrpt.html.>
[viii] Perry, Mark J. Information Age 2.0: The Cost of Hard Drive Disk Space Has Decreased by almost 1.5M Times Since 1980. 10 June 2011. Blogspot. 15 Dec 2011. <http://mjperry.blogspot.com/2011/06/heres-website-that-documents-amazing.html.>
[ix] Ritholtz, Barry. Why Michael Boskin Deserves Our Contempt. 19 Jan 2010. 16 Dec 2011. <http://www.ritholtz.com/blog/2010/01/why-michael-boskin-deserves-our-contempt/.>
[x] [x] Williams, Walter John. Government Economic Reports: Things You’ve Suspected but Were too Afraid to Ask!” 1 Oct 2006. Shadow Government Statistics. 15 Dec 2011. <http://www.shadowstats.com/article/consumer_price_index.>
[xv] Yglesias, Matthew. Mysteries of the Chained CPI Explained. 24 Jun 2011. Think Progress. 16 Dec 2011.
[xvii] Siegel, Jeremy. Stocks Can Be Your Best Hedge Against Inflation. 21 May 2011. Washington Post. 20 Dec 2011. <http://www.washingtonpost.com/business/stocks-can-be-your-best-hedge-against-inflation/2011/05/17/AFj9tc8G_story.html.>
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