Tuesday, June 17, 2008

Inflation Dimensions Keep Changing!

Every month, the Bureau of Labor and Statistics (BLS) releases their CPI number, which tells us the change in consumer prices from the month before. The CPI has been extensively used to index price increases for contracts (such as union management bargaining agreements). But according to many, the way it was calculated actually overestimated inflation. Since the 1990s, however, various changes have been made to the CPI (and still are being made) that have had the effect of reducing its reported numbers.

Unfortunately, these changes have invited criticisms from the opposite side...that inflation is now underestimated. The government controls how inflation is calculated, but it has a vested interest in keeping CPI low for several reasons. For example, a low CPI reduces Social Security obligations (which are tied to CPI). A low CPI also makes the real GDP figure higher than otherwise, which makes voters happy with the government.

Traditionally, the CPI was calculated by looking at changes in prices for a fixed basket of goods. Simple enough, right? But this doesn't take into account the fact that consumers are able to buy higher quality products for a given price. A laptop you can buy today for $3000 for example, is far superior than one you could buy 5 years ago for the same price. CPI calculations now include what they called "hedonistic pricing" to capture gains in quality, thus reducing the CPI number.

Recent CPI calculations also account for product substitution. This means the basket of goods can change because of price. If oranges become expensive, it's expected that people will buy more apples instead. In the CPI calculation, a smaller weighting will therefore be placed on oranges. Again, this has a dampening effect on the CPI number. Critics argue this substitution facility has the CPI measuring a declining standard of living. If steaks become too expensive, you may buy more hamburger meat, and the CPI says your costs are the same, despite your having a lower standard of living.

Currently, the BLS also releases what they call a chained CPI. This isn't the widely reported number in the media (yet), but it includes even more substitution, and is therefore generally lower than regular CPI.

The bottom line: Be careful of the headline CPI number. It's constantly evolving. To truly understand inflation you must look beyond the headline number to understand what is being measured.

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