Why Those Inflation Numbers Look Bogus

Gas prices have skyrocketed. You're paying more at the grocery store. So why is it that every month when the government releases the latest inflation figures, the numbers never look high enough?

The long-standing debate about the Consumer Price Index (CPI) has come to the forefront in recent months. Although extremely steep jumps in the prices of many household necessities have increased the inflation rate, many still find that the number fails to give an accurate reflection of the price increases they're seeing in their own expenses.

Gross weighs in on the Consumer Price Index
Yesterday, bond expert Bill Gross added his voice to those claiming that the CPI understates actual inflation. While his analysis refers to factors like hedonic adjustments, equivalent rental rates, and substitution effects -- the same jargon that the Bureau of Labor Statistics (BLS) uses in producing its data -- his points boil down to this: The U.S. makes adjustments to its CPI that many other countries don't, and those adjustments don't reflect reality.

Given that the government has a lot at stake with the CPI -- everything from Social Security payments to income tax brackets and inflation-adjusted bond payments rely on it -- it's easy to ascribe sinister motives for keeping the CPI low. Yet although academic arguments like Gross' are vital to the CPI debate, they aren't very important to the average consumer. Look at some of the categories that are rising the fastest:

Category

12-Month Price Change

Weighting in CPI

Gasoline

20.7%

5.2

Household heating oil

42.8%

0.4

Dairy products

11.8%

0.9

Medical care

4.3%

6.2

All items combined

3.9%

100.0

Source: BLS. Weighting refers to relative importance in calculating CPI.

Gotta have it
All these categories include necessities that people buy often. As one New York Times article has pointed out, since we see these rising prices every day, they're more likely to stick in our minds. In contrast, some of the categories that are falling in price -- things like clothing and communication costs -- are less essential and easier for strapped consumers to cut back on.

But perhaps the best explanation for why the CPI seems too low comes from how people budget their money. Many families have expenses that don't change from month to month, such as mortgage and car payments. Even though they make up a huge portion of your total spending, it's easy to ignore those always-constant costs, focusing instead on the bills that have risen sharply -- and thereby exaggerating your actual personal inflation rate.

Passing on costs
Another common element among high-inflation categories is that the companies that produce necessities typically have low profit margins, leaving them no choice but to pass on higher costs to consumers as quickly as possible. Examples include:

Company

Profit Margin

Kroger (NYSE: KR  )

1.68%

SUPERVALU (NYSE: SVU  )

1.35%

Dean Foods (NYSE: DF  )

0.80%

Tyson Foods (NYSE: TSN  )

0.63%

Source: Yahoo! Finance.

If these businesses lose their pricing power, they'll go out of business quickly. And although the major energy companies have reasonable margins, individual gas station owners often have to sell gas at a loss, counting on convenience-store sales to make money.

In contrast, higher-margin businesses that sell nonessential items often hesitate to pass cost increases onto customers. For instance, when leading-edge technology companies like Apple (Nasdaq: AAPL  ) or Research In Motion (Nasdaq: RIMM  ) see their production costs rise, their relatively high profit margins -- 15% and 22% respectively -- give them the latitude to keep retail prices down, at least for the short term. Similarly, high-end jewelry stores like Tiffany (NYSE: TIF  ) don't necessarily have to immediately pass through higher precious-metals prices in order to stay solvent.

Don't rely on the CPI
The most important lesson from this debate is not to assume that the CPI reflects the prices you're seeing. The BLS itself admits that it doesn't cover all household costs. To make sure your budget keeps up with the times, you have to consider all of your expenses.

So if the way the CPI is calculated doesn't work for you, ignore it -- or use it as a starting point for your own calculations. Meanwhile, don't expect to see the CPI debate end anytime soon, especially if prices keep skyrocketing.

For more on dealing with economic worries, read about:

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Fool contributor Dan Caplinger has seen his personal inflation rate go through the roof in 2007-08, but he's in better shape than some. He doesn't own shares of the companies mentioned in this article. Try any of the Fool's market-beating newsletters free for 30 days. The Fool's disclosure policy teaches you what you need to know.


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