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Tearing Apart the Consumer Price Index

In the past year, inflation has tacked on 4.2% to your cost of living -- or so the most popular yardstick for measuring inflation, the Consumer Price Index (CPI), will tell you.

That's a high number, of course, but if you've felt that your personal inflation burden over the past year far exceeded that figure, you're certainly not alone. Calculating inflation is a monstrous task that's bound to come up less than perfect, but the torture chamber of adjustments the CPI goes through is probably one most supreme courts would deem unconstitutional. Here are a few important CPI contortions to keep in mind.       

The substitution effect
You might as well call this one the "substitution of reality" effect. As the BLS (the organization that calculates the CPI) puts it, "... consumers can and do, to some degree, insulate themselves from the impact of higher prices by adjusting their spending to favor relatively lower-priced goods or services."

In English, this basically means that you won't necessarily feel the pinch of rising prices, provided you shift your purchase to something cheaper. The classic example: If the price of beef goes up, people switch their preference to chicken, so not all the increase in the price of beef counts as inflation -- despite any adverse effects it'd have on beef hogs like McDonald's (NYSE: MCD  ) or Burger King (NYSE: BKC  ) .

Geometric weighting
This one's related to the substitution effect. Let's say the price of gas makes up 10% of the CPI. Now let's assume the price of gas doubles in a year. To reflect this, you'd think that gas should now make up 20% of the CPI. Wrong! The weight might stay at 10%. Why? Because if the price doubles, you'll use half as much as you did before ... or so the theory goes. For many products, like gas, this is a ludicrous assumption -- even if the price rises, you likely still have to drive the same amount as you did before (or close to it).

Hedonic price changes
TV funnyman Stephen Colbert recently scored a few laughs when he quipped, "When I first started paying $4 a gallon for gas, I didn't mind. I thought I was just getting better gas." But all joking aside, the CPI uses a calculation that isn't too different.

In what they call hedonics, the prices of certain goods the CPI uses can be manipulated to reflect changes in quality. For example, if a Dell (NYSE: DELL  ) computer costs $1,000 this year, but the processor is twice as fast as last year's $1,000 computer, the CPI might chop the price down to $500 to reflect the improved quality -- even though you still have to pay $1,000 when you purchase it. While the adjustments likely aren't quite as large as my example, the dilemma still stands: The price you have to pay might not be the price the CPI assumes you should have to pay.

Seasonal adjustments
Certain commodities go through regular seasonal adjustments. Fruit and gasoline might spike in the summer, and heating oil might spike in the winter, for example. In order to smooth out any wild swings in the CPI, some prices get a seasonality makeover before they're worked into the CPI figures. Now, over the long term, these manipulations shouldn't have any real impact on the CPI, because eventually, the fluctuations will be accounted for in another season. However, these tweaks mean that using today's CPI might not accurately reflect today's real inflation -- which is kind of the point of such a statistic.

It's a big deal
Inflation's taking a big toll on our everyday lives. Dow Chemical (NYSE: DOW  ) , Kraft (NYSE: KFT  ) , Procter & Gamble (NYSE: PG  ) , and Tyson Foods (NYSE: TSN  ) , just to name a few, have all jacked up prices this year, putting a dent in your bottom line. Sure, some of the contortion techniques used in the CPI calculation are designed to more accurately reflect your price woes, but people are concerned about how much their prices are going up, not how much their consumption has to change. After all, if the price of gas goes up 10%, you can't go to the gas-station owner and say "You can't do that. According to the CPI numbers, my gasoline bills shouldn't be any higher than they were last year."

Inflation should be calculated as it is, not as it ought to be.

Further inflated Foolishness:

Kraft Foods and Dow Chemical are Motley Fool Income Investor picks. Dell is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Morgan Housel tried asking the gas-station manager for a geometrically adjusted price break. It didn't work. He owns shares of Procter & Gamble. The Fool has a disclosure policy.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 02, 2008, at 4:22 PM, valu3buff wrote:

    Out of curiosity, do you know what the rate of inflation would be if it were calculated as you propose?



  • Report this Comment On July 03, 2008, at 7:34 PM, SilverMoney wrote:

    I trust the M3 as a gauge of inflation far more then CPI. CPI doesn't count food or energy costs. Plus the Government has an incentive to keep the CPI figure low. Its what they use to increase Social Security Payments.

    M3 made secret by the Federal Reserve Bank has been increasing at over 15% the past 3 years. This is the real inflation figure and why I am buying all the gold and silver I can get my grubby little hands on.

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