Understanding Inflation – Part 1 of 6

In this 6-part series, I am going to attempt to explain something that affects all of us but something that few of us understand — inflation. If you stick with me through this series, you will find out why I think that the way inflation is calculated contributed to — or perhaps caused — the recent real estate boom and subsequent bust. But first we need to learn a bit about inflation as measured by CPI.

Inflation is more money chasing the same amount of goods. If it takes 95 cents to buy the same candy bar you bought last month for 90 cents, that extra 5 cents is inflation. To get a handle on the overall rate of inflation, someone has to track the prices of all goods and services. That job falls to the Bureau of Labor Statistics. Each month they publish the Consumer Price Index (CPI). The CPI is a measure of the average change over time of prices paid by consumers for a specific basket of goods and services. It’s basically a measure of inflation as experienced by consumers.

There are different versions of CPI, but the most commonly reported CPI is the CPI-U, also known as the all-items CPI. Since 1977, the BLS has also published what is commonly called the Core CPI-U, which is the CPI-U minus food and energy. The Core CPI (CPI-U minus food and energy) is the Federal Reserve’s favorite measure of inflation. The goal of the CPI is to determine what happens to consumers when prices go up. If the goods in the CPI basket go up 5%, consumers must increase their spending by 5% in order to remain at the same standard of living.

To put together the CPI, the BLS conducts consumer surveys. They want to know where you eat, shop and fill up your tank. Once they know where consumers purchase goods, the BLS regularly collects prices at these “outlets” to put together the various CPI indexes. They also use telephone surveys to find out what consumers are paying, and they use statistical samplings to gauge the prices of rental homes and apartments. The CPI for all items in the basket is known as the CPI-U, the overall Consumer Price Index. In the end, 211 item categories and 38 geographic areas produce over 8,000 different basic indexes from which CPI is constructed. Gasoline in Chicago, apples in Dallas, doctors’ services in Seattle and all the other indexes are lumped together to form one CPI, one measure of inflation. The goods included in the CPI basket include food and beverages, housing, transportation (including gasoline), education and communication, medical services, recreation, apparel and an “other” category that includes items such as tobacco and haircuts.

Measuring inflation is a tough job. Think about your own “basket of goods.” You probably buy gasoline. If we looked at your own personal basket of goods, we might also find that you buy a lot of compact discs and Oreos along with 90% lean ground beef, spaghetti sauce, apple juice and Tom’s of Maine toothpaste. If we tracked your basket of goods, we would probably find that your purchases change over time. You might give up Oreos, for example, in an effort to shed weight. You might start downloading music via iTunes instead of purchasing traditional compact discs. If the price of beef goes up, you might switch from 90% lean to 80% lean meat. You might keep eating the same spaghetti sauce, but you might buy orange juice instead of apple juice if orange juice goes on sale at your local market. You might also decide that Tom’s of Maine toothpaste is too expensive and go back to using the toothpaste you used to buy at the Dollar Store.

The point is that consumer behavior changes over time. Items go on sale that spur different purchasing habits, consumers switch to less expensive alternatives when prices go up, products get discontinued, and technological advances produce new options. Because of the ever-changing marketplace, the American basket of goods never stays the same. That makes tracking prices a difficult job. The people who track the American basket of goods, The Bureau of Labor Statistics, have tough choices to make.

Let’s take soda as an example. If you buy a 12-ounce bottle of soda every day, what do you do when the manufacturer stops making that size, offering only a 16-ounce alternative instead? You cannot buy 75% of a bottle of soda. It’s all or nothing. If the manufacturer keeps the price the same, how does the change affect CPI? You are now getting 4 extra ounces of soda for free. From one point of view, the price of the item has fallen. After all, you are getting more soda for the same price. The other point of view says, “But I didn’t want 16 ounces of soda! I shouldn’t even be drinking soda, so 12 ounces a day was already enough. Give me back my 12-ounce bottle of soda!” From that point of view, the price hasn’t fallen because the consumer didn’t want the extra 4 ounces. The BLS has a decision to make. They have to decide whether or not a consumer getting an extra 4 ounces of soda for the same price constitutes a price drop. These types of decisions are made by the BLS, and they directly affect CPI, the measure of inflation in the American economy. Good decisions by the BLS produce an accurate CPI, whereas poor decisions mean that CPI is not reflective of actual inflation. Incidentally, the soda-pop example used here would be handled automatically by the CPI. They would chalk this one up as a price decrease.

The Consumer Price Index was first published in 1921. The way the numbers were calculated remained the same from 1921 to 1983 when a major change was implemented. They changed the treatment of homeownership in the CPI from an asset-based approach to rental equivalence (We’ll go into rental equivalence and the other changes more in detail later on). A second major change in the calculation took affect in 1999 during the Clinton administration. That’s when they switched from straight arithmetic to the “geometric mean” formula and introduced “hedonic regression,” which is a way to make quality adjustments. To recap, here is the history of the CPI:

• Calculation unchanged from 1921 to 1983
• 1983 change in the way housing was treated. Instead of using the prices paid for houses, they began using what a homeowner would receive in rent if they chose not to live in the home (rental equivalence or the homeowner’s opportunity cost).
• 1999 switch from arithmetic mean to geometric mean
• 1999 introduction of hedonic regression, which makes adjustments for quality changes

Critics say that these changes resulted in an understated CPI, meaning that actual inflation is higher than what the government says it is. Economist John Williams says that inflation as reported by CPI is understated by roughly 7% per year. Supporters of the changes say that the adjustments have made CPI a more accurate measure of inflation. They claim that inflation was previously overstated, and since the changes, it’s now very accurate. We’ll address each of the changes in more detail later on, but before we get to that, I want to address why having an accurate CPI is so important. We’ll talk about that in Part 2 …

by Wade Young