"The inflation index, to use an analogy, reminds me of a parent who invents Santa Claus for his children and then begins to believe the fantasy himself."
-- Rudolph-Riad Younes, "A Contrarian's Take on the World," interview by Sandra Ward, Barron's, December 2007
In recent years, a chorus of commentators has heaped some pretty bold critiques on the methodology used to calculate the "inflation index," otherwise known as the Consumer Price Index or CPI. Feeling generous, I thought I'd give the government the benefit of the doubt by putting aside controversial topics such as quality adjustments and substitution effect. Even so, I still spy with my little-wage-earner eye a big reality gap between official numbers and real-life consumer experience.
The weighting is the hardest part
Similar to the construction of a stock market index, the CPI assigns weightings to a basket of commonly purchased U.S. goods and services. Given that the CPI reading provides a basis for public entitlements such as Social Security benefits, not to mention union contracts and, often, private-sector wages, one might expect weightings to be reasonably accurate.
Sorry to upset you, but I have identified three categories in which the index weighting grossly understates reported costs.
Don't drive; stay healthy; skip college
Let's start with least offensive of the examples. Gasoline accounts for 3.77% of the CPI. Back in June 2008, during the worst of the price explosion, The New York Times reported that gas prices across the country ranged anywhere from 2% to 16% of median income. Clearly, the CPI accounted for a certain slice of the consumer population, but it proved to be wildly optimistic for others.
Medical care -- a somewhat popular topic these days -- makes up 5.4% of the CPI, with the health insurance sub-category registering a minuscule 0.46% weighting. Hmm. According to the AARP, 14% of Americans under age 65 were classified as underinsured in 2007, meaning that medical expenses totaled more than 10% or 5% of family income. Better get healthy quickly so that you can pick up a second job, so the government seems to say.
How about college costs? The BLS (the Bureau of Labor Statistics, the agency responsible for administering the CPI) must be polling households on another planet: College tuition and fees represent a tiny 1.03% of the index. Meanwhile, The National Center for Public Policy and Higher Education reports that students from middle-income families must shell out 25% of their family income to attend public four-year colleges. Mind you, that's public colleges, and the statistic does not even speak to the fact that many professions require advanced degrees.
Gosh, life would be so much more affordable if we all could just stay in one place, inhaling, free of charge, optimal health and cosmic knowledge with every American breath.
Credit bridges the gap
Younes, commenting during the interview referenced above, spoke about changes made to the CPI in the early 1980s. He argued that these manipulations caused inflation to be understated by four to six percentage points in the 10 years leading up to 2007. If you think that's a whopper, independent economist John Williams uses the older methodologies favored by Younes to put current inflation roughly seven percentage points higher than reported.
As Americans, we get a bad repuation for our profligate use of credit. However, the funny math of the CPI makes a case that consumers have been forced to tap credit to make up for wage and benefit shortfalls, simply to maintain their standard of living in an era of ballooning costs. Sound familiar?
If you can't beat 'em ...
I don't expect the government to add this issue to its plate of problems anytime soon. The only recourse, as I see it, is to invest in the sectors that are underrepresented in the CPI, providing you an opportunity to fatten the brokerage account even as the ol' wallet feels the pinch.
In terms of hedging gasoline costs, I'd stay away from Valero Energy (NYSE: VLO) and other refiners because the business model does not always translate into profits during crude oil spikes. Instead, a dividend-paying integrated major may be the way to go; ConocoPhillips (NYSE: COP) and Total (NYSE: TOT) both look attractive to me at these levels.
The health-care front is tricky, given the Obama administration's focus on cost control, but it looks like companies such as Quality Systems (Nasdaq: QSII), athenahealth (Nasdaq: ATHN), and Allscripts-Misys Health care Solutions (Nasdaq: MDRX) would have to mess up in a major way not to benefit from the push toward technology-driven efficiencies.
Because Harvard isn't publicly traded (although who knows what might happen if endowment problems persist?), investment in the education sector is limited to the handful of for-profit schools. On that note, Apollo Group (Nasdaq: APOL) has recently pulled back to a more reasonable valuation.
Best of luck, Fools, because in the end, you have to watch your own back when it comes to the realities of inflation.
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