Inflation Part 1: How the Government Lies About Inflation

The following is a guest post from Marotta Asset Management. For more on the issue of inflation, see my post titled Inflation and Its Impact on Retirement.

Officially, inflation today is calculated about 4%. Unofficially, it is over 7%. Since 1997 the government Consumer Price Index (CPI) has manipulated the raw data and significantly underreported inflation.

Recently I watched the 1997 movie "Conspiracy Theory" starring Mel Gibson and Julia Roberts. Before the opening credits have finished rolling, we understand that Gibson's character is a crackpot cab driver who sees conspiracies everywhere. But our perception changes by the end of the film when we realize for ourselves that some of his theories are true.

For years I've hesitated writing about the CPI, computed by the Bureau of Labor Statistics, for fear of being compared with a paranoid character like the one in "Conspiracy Theory." The message that the government lies to us about inflation and, as a result, quietly confiscates hundreds of billions of dollars from its citizens isn't the easiest message to swallow. It only goes down when accompanied by a healthy draught of political cynicism.

What's changed over the past year, however, is that we are closer to the end of the movie. It is clearer now not only that inflation is running rampant but also that the government's numbers are still ridiculously low. More Americans have come to mistrust official inflation statistics, and therefore they are ready to understand how and why the government skews these numbers and to learn how they can protect their family's savings.

Take 2007 as an example. Bread price rose 7.4%, gasoline 8.2%, health insurance 10.1%, whole milk 13.1%, eggs 29.2%, but according to the CPI, somehow inflation was only calculated as 4.1%. This year to date we have seen an even shaper rise, which still has barely affected the official numbers.

In 1975 programs such as government pensions, Medicare and Social Security were indexed to inflation. With rising inflation in the early 1990s, public officials realized that entitlement programs made government deficits impossible to control. Politically it was just too difficult to cut spending to this program. It was much easier simply to lower their cost-of-living adjustments.

So a commission of five economists in 1996 studied the CPI and issued a report stating that the index overstated inflation by at least 1.1%. Lower CPI adjustments would not only save money in entitlement programs but also raise tax rates mostly among the middle class. Tax brackets, personal exemptions and the standard deduction are all indexed for inflation. Lowering these adjustments has the effect of increasing the tax paid, with the greatest impact on middle-class taxpayers.

The argument that the CPI was overreported went something like this: In 1970 a mid-priced car cost about $3,500. Today, in 2008, the same size car costs about $25,000. After adjusting for inflation using official CPI data, today's car costs $4,515 in 1970 dollars.

It certainly looks like inflation has been significantly underreported, even though the government argues the exact opposite. In their 1996 study, they suggested that although it looks like today's cars are more expensive even in inflation-adjusted dollars and that CPI has been underreported, in fact it is the opposite. They claimed that today's cars are simply better built.

According to their logic, what we called a car in 1970 doesn't even qualify to be called a car today. It wasn't fuel efficient. It had no airbags, no power windows, no power door locks, no heated seats, no tilted steering wheel and no CD player.

The government has decided that the enjoyment you get from all of these extra features is why a car costs more today. Thus you are buying a better model than you did in 1970 and therefore it should cost more. The extra pleasure you get from the car should be measured as your choice, not as inflation.

You can see the problems with these government assumptions. You still need a car today. Apparently, you can't buy what we used to call a car in 1970. A combination of government mandates and changes in market preference have added features. Rather than being able to take advantage of these improvements simply because you are living in the 21st century, these improvements have diminished the value of your currency.

The official term for this type of adjustment is a "hedonic deprecator." If the computers available this year are twice as fast, then the government counts that as 50% deflation. You are getting twice the hedonism for the same dollar, so only half the price is reported in the price indexes. It evidently doesn't matter that you paid the same price. And it doesn't matter that a computer at the old speed won't run any of the new software.

Hedonic adjustments are a way to discount any improvements in productivity. Under the old method, when a reserved Federal Reserve kept inflation in check, productivity improvements resulted in every dollar of your paycheck buying more. Now, an unreserved Federal Reserve deflates the value of every dollar. By counting the bonuses from increased productivity, the government does not need to report the real inflation it is causing.

Not everything is more expensive. Clothes cost less, thanks to continued globalization. And communications costs less too, along with many other electronic gadgets. However even these items are used against consumers. In a concept called "creative substitution," the government CPI numbers did not count electronics when they were expensive but now counts the drop in their price as anti-inflationary.

The government's argument is that very few people owned a calculator when it cost $100. But now that the same calculator can be purchased for $5 and everyone owns one, it should be counted as deflationary. According to this mindset, the fact that your calculator and cell phone each costs $100 less should more than make up for the fact you can't afford to buy basic foodstuffs or drive your car.

With food, the government adjustments are a little more imaginative. They assume if the price of beef goes up, you will eat less beef and more chicken. If chicken goes up, you will choose pork. And if pork goes up, you will eat more tofu. They assume that when the price of something goes up, some people creatively substitute something less expensive.

Lacking any standard for a U.S. dollar, we can make two observations: your currency has been devalued, and this devaluing is not reported as inflation. Standard of living improvements due to technological advancements have been withheld from those who are on fixed incomes and those who keep their wealth in dollar-denominated investments.

It was none other than former Federal Reserve chairman Alan Greenspan who in 1966 wrote, "In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value."

Unreported runaway inflation has made dollars unappealing to hold. This is good for our trade deficit because those outside the United States now want to trade dollars of diminishing value for real goods and services, but it could have detrimental effects on our country and its citizens. Next week we will describe those effects and how to protect yourself against them.

Comments

[1WineDude]

*Great* explanation!

If you also throw in wage stagnation (which has more or less been the case for most white-collar jobs for a few years running) and you have an even more complex (not to mention more frightening) picture when it comes to inflation.

[Mox]

Many economists diagree with this viewpoint and think that CPI vastly overstates inflation.

Here's an alternative view from Don Boudreaux, an economist at George Mason:
http://www.pittsburghlive.com/x/pittsburghtrib/s_425055.html
http://www.pittsburghlive.com/x/pittsburghtrib/s_428167.html
http://cafehayek.typepad.com/hayek/2006/09/cpi_bias.html

[traineeinvestor]

Yep. Exactly right. CPI numbers generally understate inflation and, as you have pointed out, this can be verified rather than dismissed as another conspiracy theory.

The question to consider is: "what are the implications?"

CPI understating inflation has a number of implications:

1. TIPs are a bad investment

2. cash, CDs and the like are depreciating in real terms faster than you think

3. debt finance is under priced

4. inflation indexed benefits (pensions etc) are not really keeping up with inflation and will lose real value over time

5. asset allocation need to be revisited.

Any others?

[David Wynn]

Interesting post. However, I think the problem the author has lies in conflict between what he thinks the CPI should measure and what it's explicit goals are.

I would argue that the practices he thinks are underhanded are trying to get at something more nuanced than he's looking for in a measure of inflation. Economists care about the abstract buying value of a dollar, and they go after finding that "price of money" with quirky abandon. They want to be VERY specific when they measure value from year to year.

Thus in my view, I don't think they're trying to actively suppress inflation rates, but trying to get at some sort of "true" value of a dollar that the author doesn't really care about. The author here wants to talk about price increases, but he never seems to acknowledge that increased demand, as well as technological change, has to be factored out of price increases for a viable estimate of inflation. Every rise in price doesn't necessarily correspond with a devalued dollar, so much as it could indicate greater demand for the good.

Food has undergone a shortage. The rise of China and India coupled with fears about long-terms stability in oil flows have driven up gasoline. And last time I checked, depending on what kind of car you want, you can still get one pretty cheap. I saw a Kia dealer the other day giving away any car for a dollar if you bought an SUV too.

Inflation can certainly a problem, and estimating it isn't a perfect science. I agree that a gold standard (or some other non-floating standard.... which isn't even really true in the case of gold given the mining industry) would protect the value in a single dollar, but there are benefits to having a flexible currency as well. I wouldn't be willing to throw out the baby with the bathwater in trying to combat inflation for its own sake.

[Lord]

I think inflation may be overstated during normal times as people can substitute away from higher prices, but may be understated during times of commodity inflation as people must substitute towards higher prices of necessities.

The question someone who believes in much higher inflation needs to answer is how much their income rose and if this was less and they didn't borrow more, then where did they cut back? If they cannot answer this they may be overestimating it.

[Lazy Man and Money]

I lost you at the car analogy. You can get a car for a lot less than $25,000 today... and that car will still have more features than the average one in 1970. You can get a Kia with many of the extra options of today for around $12,500 (half the price cited).

So at $12,500, you are still getting more for your money - at least fuel efficiency, air bags and other safety advances). My rudimentary math says that it's cheaper than the less advanced 1970's mid-priced car when adjusted for reported inflation.

[RWH]

The author mentions the rising cost of food as one part of inflation. If that's the case, then maybe the USDA is lying to us:

http://www.extension.iastate.edu/AgDM/articles/hof/HofOct07.html

The first chart shows the cost of food as a percentage of income has dropped from 18% in 1960 to 10% in 2007.

You can find similar data on the price of gasoline. While it is at historical highs in real dollars, it is less today as a percentage of income.

I'm not arguing that we don't have inflation. But in general, we are more affluent today and have more disposable income than at previous periods in our history. People should remember that.

[Cameron C.]

Very interesting read, especially the comments that followed.

Thanks for the post!

[Mike Hunt]

Great post FMF, and some good comments back on this.

I would say there is wage deflation going on and the purchasing power of the average person is going down. Given that annual adjustments for people on fixed incomes (social security, etc) are to preserve purchasing power, it is clear that these people are feeling the pinch. I believe that Ron Paul has stated this and called for a more tough stance on preserving price stability.

Mike

[Kyle]

I completely reject the idea that the government is manipulating inflation numbers. Hedonic adjustments are a statistical necessity. Without them, the numbers are flat-out incorrect. Ask yourself this: would you be willing to pay more for a product that was superior to its competition? On average, most people would. If this statement is true, hedonics are necessary. A statistic that does not attempt to control for all variables relative to the outcome is quite simply an invalid statistic.

[MelMoitzen]

Has anybody bothered to look at the details of how the CPI is calculated?

http://www.bls.gov/news.release/cpi.t01.htm

This is *not* a one-size-fits-all formula, but I think it is fair. Harp all you want about items that are going up--and your personal CPI may be up 7% or higher in the last year--but clothing is pretty much down in the last year and housing is fairly flat. There are clotheshorses and those entering the housing market to buy for the first time, or renting from landlords at bargain prices who have done quite well in the last year. I use mass transit and fill up my gas tank perhaps every three weeks, so increasing gas costs aren't affecting my personal CPI the way they are the guy who's driving 75 miles each way to work.

Just because your own personal CPI happens to be greater than 4% doesn't mean there's a conspiracy theory--it just means that you've got a higher ratio of the pricier CPI components in your spending mix than the next guy.

[Jim]

The article is claiming that CPI is an incorrect measure of inflation. OK so based on that claim then what is the correct measure of inflation and where is the data to back that measure? If CPI is wrong as claimed then what is correct?

CPI is meant to be a broad general average of prices. They have to pick something to measure and it isn't going to be absolutely perfect. But I don't see any actual data here really supporting the claim that the CPI is "wrong" or that the numbers are bad.

If you think the numbers are off then shows us and prove it.

Jim

[Rob in Madrid]

British taboilds have been running headlines to the same effect, that the goverment underplays inflation. The real rate of inflation according the Daily Mail is about 10%. Also saw this comment from a link from GRS.

POSTED BY: Dody (July 07, 2008 10:41 PM)
" inflation is running ahead of its long-term average of 3.4%. Kiplingers is looking for prices to rise about 4% over the coming year. That's still a far cry from 30 years ago, when the rate of inflation hit 11.3% in 1979 and peaked at 13.5% in 1980." Back then they used different measures to determine the inflation rate. If you measured inflation by the original measures I am certain we would be some where in the same area as 1970 or 1980. I am so tired of reporters posting this gobbly-gook without doing their homework. I was BORN in 1980 and I know better. Stop comparing apples to oranges...In chemistry you always have to convert to the same unit of measure, the CPI and inflation gauges are not in the units of measure because the way to measure the units have changed. Plug modern data into the original way to measure the units and I am certain our current inflation is close to or above that of 1980...

[Ed Moore]

The CPI is a mumber fabricated by the Government, the Bureau of Labor and Statistics (BLS). The BLS has (8) seperated methods, given it by congress by which it can legally massuage the data until they arrive at the required figure. The goverment has every reason the keep the CPI number they fabricate low. Several of these reasons have been address in other posts.

A very important reason to keep the BLS CPI number low is it's connection to GDP. If the BLS released a CPI that represented reality, GDP would have been negative for the last few years. The fact is that the USA is now and has been in recession for the last few years. This is the last thing the US Government wants Americans and the world to understand, thus the sham.