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Thursday, February 3, 2011

Inflation: Does the CPI Capture Reality? (published in December of 2010 in the SB News Press)

Yesterday, I dropped my truck off at Richard’s Accurate for some repairs.  While speaking with Oren, he mentioned that Interstate Battery has raised their core battery price from $5 to $25, because the price of lead has increased so much.  This made me think about inflation in general, and more specifically, about how the official calculation for the CPI (Consumer Price Index) doesn’t really capture the realities the average person faces with regard to price inflation.

The Consumer Price Index is the government's key inflation indicator, and The Bureau of Labor Statistics calculates the CPI each month. This index is based on data related to consumer spending habits and the prices paid for a variety of goods. 

The CPI reflects spending patterns for each of two population groups: all urban consumers and urban wage earners and clerical workers. The all urban consumer group represents about 87 percent of the total U.S. population, and is based on the expenditures of almost all residents of urban or metropolitan areas, including professionals, the self-employed, the poor, the unemployed, and retired people, as well as urban wage earners and clerical workers. Not included in the CPI are the spending patterns of people living in rural nonmetropolitan areas, farm families, people in the Armed Forces, and those in institutions, such as prisons and mental hospitals.

The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. For the current CPI, this information was collected from the Consumer Expenditure Surveys for 2007 and 2008. In each of those years, about 7,000 families from around the country provided information each quarter on their spending habits in the interview survey. To collect information on frequently purchased items, such as food and personal care products, another 7,000 families in each of these years kept diaries listing everything they bought during a 2-week period.  Over the 2 year period, then, expenditure information came from approximately 28,000 weekly diaries and 60,000 quarterly interviews used to determine the importance, or weight, of the more than 200 item categories in the CPI index structure.

The CPI represents all goods and services purchased for consumption by the reference population BLS has classified all expenditure items into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows:

Food and Beverages
Medical Care
Education And Communication
Other Goods and Services

Also included within these major groups are various government-charged user fees, such as water and sewerage charges, auto registration fees, and vehicle tolls. In addition, the CPI includes taxes (such as sales and excise taxes) that are directly associated with the prices of specific goods and services. However, the CPI excludes taxes (such as income and Social Security taxes) not directly associated with the purchase of consumer goods and services.  The CPI does not include investment items, such as stocks, bonds, real estate, and life insurance. (These items relate to savings and not to day-to-day consumption expenses.)

For each of the more than 200 item categories, using scientific statistical procedures, the Bureau uses samples of several hundred specific items within selected business establishments frequented by consumers to represent the thousands of varieties available in the marketplace. For example, in a given supermarket, the Bureau may choose a plastic bag of golden delicious apples, U.S. extra fancy grade, weighing 4.4 pounds to represent the Apples category. (Bureau of Labor Statistics website)

Although the BLS method is highly complex and thorough, it is also a very generalized approach, intended to represent the big picture for inflation.  While debate rages on about the effectiveness and accuracy of the calculation of the CPI, the reality is that each individual’s experience rarely relates closely to CPI. 

When working with my students at the University of Phoenix, I always state that today, for most of us, it feels like we are working twice as hard for half the money.  While this statement is intended to elicit a response from students, it may not be that far from reality.  Even at an inflation rate of just 3 percent, it would take only 24 years to double prices.  Unfortunately, given the enormous level of our national debt and budget deficits, it is highly likely that inflation will rise well above 3% in the near future.  (With an inflation rate of 6 percent, it would only take 12 years to double prices.)

The problem with inflation is that incomes rarely increase at the same pace, which means that, as prices rise, the average person’s purchasing power is eroded more and more (assuming their income does not increase). 

In 2008, when oil prices rose to nearly $150 per barrel, we saw an immediate and dramatic impact on consumers.  The freeways of America were littered with cars that had run out of gasoline, since their owners, living paycheck to paycheck could not afford to buy gas.  So many of us are living on the edge, so that only a relatively small increase in prices can have a very material, negative impact on our standard of living.

Gold and many other commodities have risen dramatically in price recently precisely because of the national debt, budget deficits, and the potential for inflation.  Despite what the official CPI calculation might show, when we go to buy food, gasoline, or just about anything else that is produced with raw materials, we are seeing sizable price increases that have a direct impact on our monthly living expenses.  This, of course, translates to our ability to save and invest—two things that our economy desperately needs. 

Obama, just this week, agreed to a compromise on extending the Bush tax cuts for two more years.  While I agree that this was necessary, it will mean that government revenues will be lower than they would have been, if tax rates had risen back to previous levels.  Lower government revenues mean a higher budget deficit and a higher national debt; a debt that someday we are going to have to pay back.

There isn’t much we can do about inflation, other than plan for it, save our money, reduce our expenses, and possibly buy gold or other inflation hedges (gold is very expensive already, so it may not be such a great inflation hedge at present).  We can also prepare for the likelihood that real estate prices will decline further, as mortgage rates increase.  Additionally, we can expect that the Fed will be forced to raise short-term interest rates—the Fed Funds rate and Discount Rate—which will pressure rates across all maturities, and will increase borrowing costs. 

More importantly, higher rates will have a significant cooling effect on the economy, and potentially could push us into another recession, if the Fed is forced to raise rates rapidly to combat inflation.  Historically, the Fed has been more concerned with fighting inflation than will supporting economic growth, so it is likely that they will push rates higher to slow inflation, even if it means crushing the economy in the process.

The latest round of quantitative easing (QE) flooded the market with $600 billion in new dollars, although one could argue that the majority of those dollars went to foreign investors who sold their treasuries back to the government.  Many have suggested that we will need as much as $2 trillion in QE to prevent another recession.  If this is the case, the potential for inflation will increase even more, and the possible consequences of inflation on the economy, and on you and I, will increase sizably as well.

One thing is certain though—prices will continue to rise relative to our incomes, at least for the foreseeable future, so it is best to expect this outcome and to prepare for it, even if it’s painful to contemplate.  

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