The CPI Is Broken. Here's Why.

I believe in Santa Claus. I don't believe in the Consumer Price Index. One is a real guy who delivers the goods. The other is a manufactured number that does not.

I've argued before that the CPI is missing heavy undercurrents of inflation, which an abundance of very lively secondary indicators tells us has already arrived in force. Recently, one Fool editor challenged me to identify why those secondary indicators were contradicting the CPI, and investigate exactly what was faulty about this index.

Challenge accepted.

How I know
Before we examine the CPI itself, I'll quickly restate the ways in which the market is telling us that inflation has arrived. Commodity prices are soaring. Companies ranging from McDonald's (NYSE: MCD  ) to AmBev (NYSE: BUD  ) to United Technologies (NYSE: UTX  ) are raising prices. U.S. dollars are falling in value. The stock market is rising. Gold is shooting through the roof. These are the secondary indicators I mentioned, all telltale signs. On the other side of the debate is the Fed, which asserts that inflation levels are significantly less than normal, using the CPI to confirm. Why the disconnect?

A big-picture view
I'm not going to mechanically dissect the government's CPI methodology, because I think most of it is OK. Instead, I'll stick with the big picture and try to focus on one issue. The largest problem with the CPI revolves around its largest input: housing.

More than 40% of the CPI is based on a composite of rent and rent equivalents from major housing markets across the country. That's a very big number for just one item, but the magnitude of the number itself is not necessarily the trouble. It merely intensifies three other underlying problems:

  1. Fluctuations in housing prices are not shared equally.
  2. Changes in housing costs aren't experienced in real time.
  3. Everyone's housing situation is different.

No, Virginia, there is no U.S. housing market
The U.S. has no one single housing market. Instead, it has a fusion of numerous regional and local housing markets. The Bureau of Labor Statistics (the owner of the CPI) is sensitive to this, calculating local CPI numbers in addition to the national CPI number. But the national CPI number gets used to justify strategic decisions on inflation, and therein lies the problem.

If you live in D.C. (as I do), your housing situation is a lot different than that of a person who lives in Cleveland. Yet the national CPI number doesn't think this way. Instead, the disproportionately large and negative pressure on home prices coming from select cities such as Cleveland, Detroit, or Miami is likely to bog down the national CPI number, obfuscating what may be a more accurate and representative figure for people living elsewhere.

That's just one example. The larger point is that housing costs are simply too variable to be captured with one neat number. Real Inflation could easily occur right under the nose of the CPI, simply because there are so many subcurrents in housing prices pushing in different directions.

When do housing costs actually rise?
Our second problem is a bit more abstract. Typical Americans don't experience changes in housing costs nearly as quickly as changes in other cost components of the CPI index.

If you're a renter, you've probably locked in your rates for at least a year, if not more. If you're a homeowner, you're likely to have locked in your mortgage rates for a very long time. You probably won't face fluctuations in home prices again until you're looking to move. Combine that point with another important aspect of housing prices.

If you believe that home prices act as a lagging indicator behind the general U.S. economy (a plausible, but not absolute argument), then you'd sign up for the logic that home prices will only rise after people are convinced that the U.S. economy is healthy again, and after they begin to bid the price of homes up again. All of that takes time -- and we're clearly not there yet as a country.

While inflationary effects manifest themselves more rapidly in other parts of the market (food, gas, etc.), there might be a significant delay before they start influencing housing prices. It's quite likely that the CPI is not fairly representing the real-time inflationary picture because it's being weighed down by much slower-moving housing prices.

What is normal?
The third problem is more contemporary. Thanks to the housing crisis, more and more Americans are choosing to live in nontraditional arrangements. College grads (with and without jobs) are moving in with their parents. Multiple families are living with one another. People are discovering novel ways to deal with housing costs. According to a New York Times article, as of 2008, nearly 50 million Americans lived in households with two or more adult generations. Since then, I'm sure that number has grown.

One important implication of this data is that a massive number of Americans might exist outside the realm of the CPI's effective cost calculations. Plus, what about people who live in homes that are paid off? What about people in government-subsidized housing? What exactly is a "normal" living situation?

Housing costs could easily drop across the board at the same time that many millions of Americans suffer from cost increases in other parts of life. Do these people not feel inflationary pressure, simply because they don't live in what the CPI classifies as a normal housing situation? Here again, I find the CPI's treatment of housing a bit too simple.

Here's the real problem
The CPI appears to treat housing costs as a static, collective experience for all Americans. But the reality is much different. Housing is a beast completely unto itself.

Fortunately, there are collective spending experiences out there. Unfortunately, they're telling us exactly the opposite of what the CPI is telling us.

More appropriate indicators of inflation are the costs that Americans tend to face together, much more equally -- costs like food, gasoline, heating oil, consumer goods, and numerous other everyday expenditures. These numbers are advancing quickly, despite the housing picture.

Fools being Fools
Any index that is 40% fed by problematic information will be at least 40% problematic in its result. Make no mistake: The implications of a poorly calibrated CPI are huge. If the CPI is used to make decisions on topics as important as inflation, and it's not accurately capturing the financial realities of Americans, there's a big problem. I believe housing lies at the root of the CPI's troubles.

I want to hear what others have to say about this issue, so I invite Fools to debate below. Have I got it wrong? Is the CPI working?

Fool Nick Kapur believes in Santa Claus. He owns no shares of any company mentioned above.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On December 10, 2010, at 1:09 PM, pohick2 wrote:

    more ranting on this topic here

    http://nowandfutures.com/cpi_lie.html

    the problems of taxes, education, medical costs

    are not well dealt with

    this impacts productivity, purchasing power parity, and standard of living

  • Report this Comment On December 10, 2010, at 2:17 PM, lctycoon wrote:

    Anybody who thinks that there has been next to no inflation in this country over the last year obviously does not purchase their own gasoline or food.

    The CPI "excludes" fuel and agricultural products. These are big spending categories for many, many Americans.

    Housing values have gone down in the last year, in aggregate. Where I live, they have gone up... but then prices for homes did not fall here - they kept going up straight through the recession. But, with housing, in general, falling the CPI number is skewed.

    If the CPI were calculated the same way it was during the Great Depression, it would be 7%. Then again, unemployment would be at 17.6% or so.

    These numbers are manufactured for political purposes as an attempt to trick the people and make everything look better than it is.

  • Report this Comment On December 10, 2010, at 2:43 PM, zymok wrote:

    CPI includes fuel and food. The so-called "core" CPI excludes fuel and food and is used by the Federal Reserve as a less-volatile measure of inflation. Legislated uses of the CPI generally include the fuel and food measures.

    Here are some quick numbers on the housing impact on CPI:

    BLS reports an unadjusted CPI-U from October 2009 to October 2010 (the first set of values I came across when I did a web search) of 1.2%. During this same period, housing declined by (-0.2%). Using a 40% weighting for housing, this means that the "housing-less CPI-U" rose by 2.1%.

    So housing brought the CPI-U down by 0.9 percentage points. I suppose that whether or not this is "broken" depends on your application, but considering the very abstract nature of the CPI I find it hard to get really worked up about it.

  • Report this Comment On December 10, 2010, at 3:10 PM, ouchtouch wrote:

    Part of the problem with the debate is definitions. We are experiencing deflation, meaning the money supply is decreasing, because people are deleveraging, paying down or defaulting on debts. But commodity prices are going up, partly or largely because the Fed is pumping liquidity into the market and that liquidity is going to commodities. The fed wants to stop deflation, which it cannot do. The weapon the Fed is using is pointed right at the consumer's head, instead. We need to stop trying to fight an unstoppable force, and allow asset prices to normalize, and debts to be paid or defaulted away, before the economy can recover.

  • Report this Comment On December 10, 2010, at 3:33 PM, ETFsRule wrote:

    Interesting analysis, but I'm not really convinced. Do you think housing should be left out of the CPI altogether?

    Or should CPI be calculated for various regions, but not for the country as a whole - to compensate for the wide variations in different housing markets?

    Housing makes up a very large % of the average family's expenses, so I think a drop in housing prices is very significant. Even if you aren't buying a house right now, you can save money by refinancing... I've refinanced twice in the past 2 years, and I'm saving about $150 per month as a result.

    I haven't seen many price increases in my day to day items. And I think you have missed an important economic indicator for the deflation side of the argument: savings rates. Instead of buying lots of stuff on credit, the typical family is paying off their debts, and saving their cash:

    http://research.stlouisfed.org/fred2/graph/?chart_type=line&...

    That sure doesn't seem like an indicator of inflation to me.

  • Report this Comment On December 10, 2010, at 4:03 PM, dnirenberg wrote:

    If you own a house and house values fall, that hardly makes the fact that everything else went up in price seem more managable.

    The other issue is the index "corrects" for improvements. If the price of a computer (or car), for example, stays the same but the power or features increase that's corrected to be a price decline. One gets the feeling that corrections in this direction are made more freely than in the other direction. Airine seat prices are stable but the service is worse and the planes more crowded; does that get "corrected" to be a price increase?

  • Report this Comment On December 10, 2010, at 5:45 PM, TMFTheSnake wrote:

    dnirenberg

    The service may be worse and the planes may be more crowded, but are they crashing more or landing in unexpected places more often? I would argue the price of a plane ticket (at least the economy class ones I can afford) mainly pays to get me where I want to go quickly and without me having to pay attention to the steering wheel.

  • Report this Comment On December 10, 2010, at 5:59 PM, NOTvuffett wrote:

    If as the govt. claims, inflation is about 0%, why are they giving social security recipients a payment in lieu of a cost of living increase (which would have been $0 otherwise)?

  • Report this Comment On December 10, 2010, at 6:07 PM, mtf00l wrote:

    @NOTvuffett

    Now that is an interesting question...

  • Report this Comment On December 10, 2010, at 7:06 PM, TopAustrianFool wrote:

    The CPI is indeed broken since it doesn't show the 8 - 10%/yr inflation since the Panic of 2008. When you have house prices not dropping when the BANKS are holding them for years and when companies are increasing their profits and not hiring, that is inflation my friend.

  • Report this Comment On December 10, 2010, at 10:10 PM, ChrisFs wrote:

    "If you're a renter, you've probably locked in your rates for at least a year, if not more"

    I think you are way wrong on this. The vast majority of renters I know, including myself are on month to month rental agreements. In SF Bay Area, and I suspect many big markets, year long leases are rare, because a landlord can easily get someone else in if they need to, so why be contractually stuck for someone for a year?

  • Report this Comment On December 10, 2010, at 10:17 PM, zymok wrote:

    NOTvuffett

    I'll give you two answers to your question.

    The first and politically correct answer is that inflation experienced by the elderly is greater than that experienced by the general public, because the elderly are more sensitive to the rising costs of health care and less sensitive to the declining costs of housing.

    The second and real answer is that the politicians are buying votes.

  • Report this Comment On December 11, 2010, at 8:04 AM, irvingfisher wrote:

    I haven't looked at huis issue lately, so my memory is a little fuzzy. Correct me if I'm wrong. I think that. Te early 90s, the way the CPI is calculated was adjusted to take into account increases in the value of goods. If a certain is perceived to increase in value (along with the price increase), the calculated inflation for that good is adjusted down.

    For example. The price of a SUV may go up, but the price increase is adjusted down to reflect the value of all the new features, like side-impact airbags.

    Consequently, prices have increased more the CPI indicates.

    It would be nice to see an article on this, especially comparing the CPI with a calculation of inflation that is not adjusted for perceived increases in the value of goods.

  • Report this Comment On December 11, 2010, at 12:53 PM, rx100 wrote:

    It would seem that automobiles are the second largest expense after housing for most families. In fact over a lifetime many families spend more for the transportation than the housing. We like our accessories but the fact is many vehicles are not available without a lot of the new features which is forced inflation.

    How does this fit into the CPI?

  • Report this Comment On December 11, 2010, at 1:55 PM, GCMays2010 wrote:

    You make some outstanding points about housings inclusion in the CPI possibly depressing overall inflation. However, we get a much more realisitic picture if simply did not exclude anything.

    As everyone knows, the Fed excludes food and energy from its numbers, which is a significant part of everyone's daily life, whether you live with your parents or have your own place.

    Simply using the numbers as they are in conjunction with the PPI would show us that many of the price increases are being absorbed companies who interface with the end user.

    http://maysreport.com/2010/11/17/october-consumer-prices-hol...

    In some cases it shows up in lower profits and in others profitability has been maintained by controlling labor costs (no hiring, using overtime). Either way, I agree that the Fed needs to be more realistic in its approach to measuring inflation.

  • Report this Comment On December 11, 2010, at 3:21 PM, zymok wrote:

    GCMays:

    The Fed doesn't measure inflation. The BLS does, and the BLS includes food and energy in the CPI. The core CPI (i.e. CPI excluding food and energy) is used by the Fed specifically for monetary policy.

    The inflation number of 0.2% that is quoted in your link is the all-items values. Mays doesn't give a source, but this is apparently what he's referring to:

    http://www.bls.gov/news.release/cpi.t01.htm

    Note that the "all items" monthly inflation number is 0.2%. If you scroll to the bottom, under the "special indexes" section, you'll find the core CPI listed all "all items less food and energy". For October, this increased 0.0%.

    others re quality adjustments:

    Hedonics is a small but widely misunderstood part of the CPI calculation. Relatively few items are subject to quality adjustments, and these are done when necessary after considerable statistical analysis.

    Here's a link that explains things pretty well:

    http://www.bls.gov/cpi/cpihqaqanda.htm

  • Report this Comment On December 11, 2010, at 3:34 PM, goalie37 wrote:

    I have had a question about CPI, and maybe you can help. Are wages included?

  • Report this Comment On December 11, 2010, at 3:42 PM, zymok wrote:

    Goalie:

    No. Since wages are not a consumer cost, they are not included in the CPI. However, there are separate measures of wage changes. I don't have a link handy, but as I recall BLS calculates various wage statistics such as median earner, median household, hourly rates, percentiles, etc. The census bureau may have there own measures as well.

    You can also find wage statistics in constant dollars, i.e. wages with inflation factored in.

    Hope this helps.

  • Report this Comment On December 11, 2010, at 3:52 PM, goalie37 wrote:

    Thanks zymok.

  • Report this Comment On December 11, 2010, at 4:02 PM, GCMays2010 wrote:

    zymok, Of course I know that the fed does not measure inflation, I am an analyst. LOL.

    Let me clarify, the Fed USES CPI data which excludes food and energy in conjunction with the taylor rule when it decides whether inflation is meeting its target.

    I hope that is clearer. LOL.

  • Report this Comment On December 11, 2010, at 4:13 PM, TopAustrianFool wrote:

    "whether inflation is meeting its target."

    I know the Fed claims a "target inflation" which translates into "target robbery" from people who save. Inflation is the way to tax you without you knowing it. Thieves.

  • Report this Comment On December 11, 2010, at 4:35 PM, GCMays2010 wrote:

    @TopAustrianFool - Inflation is not a tax that is determined by the Fed. Inflation simply measures the level of prices in an economy. The Feds "target" is not a tax, but where they would like to contain the rate of change of the price level.

    The discussion is about what is included in inflation. So called "core" CPI vs the overall CPI number.

    The Author asserts that housing should be excluded because its price level varies by geography. The Author is thinking in absolute terms.

    What the author is overlooking is that housing, like every other price, is relative to income in a given local area. What one makes in DC is not what one would make for the SAME JOB in Cleveland.

    I agree that "overall" CPI should be what is used to measure inflation and not core. But to exclude housing because prices have fallen (they are not done yet) from their bubble highs is not the right solution.

  • Report this Comment On December 11, 2010, at 5:23 PM, zymok wrote:

    GCMays

    Thanks for clarifying. It's often difficult to distinguish in a post between a slip of the tongue (or fingers) and a genuine misconception.

  • Report this Comment On December 11, 2010, at 7:07 PM, TopAustrianFool wrote:

    GCMays2010:

    You write: "Inflation is not a tax that is determined by the Fed. Inflation simply measures the level of prices in an economy."

    It is actually no different than a tax. And it is indeed determined by the Fed. The Fed dictates the interest rates by buying about 1/3 or 1/2 of the bonds issued at any given time, thereby artificially creating a demand that allows for treasuries to be sold to China at a lower interest rate than a free market would dictate. The Fed also dictates to treasury the amount of cash it wants printed in order to buy these same bonds, that is where your inflation comes from. So treasury prints, then it gives the money to the Fed which in turns uses the money to buy the bonds the Treasury issues and all of this game depreciates the currency. Every country does this, but the US has always managed to do it at a much lower pace than other countries.

  • Report this Comment On December 11, 2010, at 7:34 PM, GCMays2010 wrote:

    @TopAustrianFool

    We could go back and forth on what factors impact interest rates, exchange rates, the price level, what the Fed does and/or doesn't do etc. However, in this case I think it best that we simply respectfully disagree on this one.

    Great discussion.

  • Report this Comment On December 11, 2010, at 7:35 PM, GCMays2010 wrote:

    @zymok. No worries mate.

    Good Discussion.

  • Report this Comment On December 11, 2010, at 8:42 PM, dunsmuir01 wrote:

    The bedrock to Kapur's argument here (made more than once) appears to be that rising commodity prices fuel inflation. That on the surface seems reasonable. But guess what: looking at the long term evidence, they actually don't:

    http://blogs.wsj.com/marketbeat/2010/12/10/stop-crying-infla...

  • Report this Comment On December 12, 2010, at 7:27 AM, TopAustrianFool wrote:

    GCMays2010:

    " interest rates, exchange rates, the price level"

    All of these are dictated by monetary policy and the amount of money issued, which are both dictated by the Fed. There is no argument. The Fed controls it all and if you can't agree about that then you are missing how inflation works. What you are mentioning are good ways to measure inflation, but a measure of something is not necessarily its origin.

  • Report this Comment On December 12, 2010, at 12:28 PM, kwl1763 wrote:

    Why reinvent the wheel.

    You often here the CPI ex food and energy or the "core" rate. Why not have one that excludes housing. Call it an short term CPI or something like that. The problem is there is no good way to do it. But I do agree housing though a huge part of peoples spend is not volitale or likely changed in the short run so really should be excluded in anything except minimum of yearly increments.

  • Report this Comment On December 13, 2010, at 8:46 AM, TopAustrianFool wrote:

    Keneysians always exclude from the CPI what ever increases its measure. Due to govt policies, inflation tends to reflect itself first in housing, food and energy therefore in order to have a low CPI they exclude all of these, that way they can tell you that it is low and under the Fed's target. Its a game and a fraud.

  • Report this Comment On December 13, 2010, at 10:43 AM, CrimsonMaize wrote:

    I don't think your arguments are very compelling.

    First of all, siting the fact that housing prices (and prices in general) differ from one region to another is not an idication of CPI being broken. It's a claim that the country should not have a common currency or monetary policy.

    Secondly, even if excluding housing from CPI made sense, you don't really think through the alternatives. You just make a vague argument that monetary policy should be focusing more on items with increasing prices than those with decreasing prices. Kinda arbitrary.

    Also, to imply that the Fed only looks at core CPI is a dangerous oversimplification. The BLS reports dozens of different permutations of CPI. Don't feed the flames of the ignorant frustration-aggression by portraying decision-makers as charicatures of oblivious automotons. The truth is, it's complicated.

  • Report this Comment On December 13, 2010, at 11:13 AM, jasonhad wrote:

    You betcha booties it's broke! As a homeowner, my mortgage has not budged, but Ben thinks I pay less because he's tanked interest rates - my bank won't refinance me, because my house is now worth less than needed for an 80% Loan-To-Value, so no help there, Ben. My taxes go up on the house 3% a year - year in, year out. So does the fire insurance, That's an INCREASE, Ben. Energy? up,up and away! Gasoline is back above $3 a gallon, electricity sneaks up by tiny increments seemingly every bill. Food? Ben, have you even been to a grocery store this year? I can't name any basic food that has decreased in price this year. And of course, you assume every year that I am trading down to save money. How do I trade down from a ten-pound sack of flour, Ben?

  • Report this Comment On December 13, 2010, at 1:44 PM, Atheist4816 wrote:

    You have to be careful in what you are measuring in an economy using any type of inflation index.

    It is arguable that when housing costs rise they act as a brake upon all other expenditure hence producing an anti-inflationary environment.

    When you do include housing and gas what you are measuring only has meaning when compared to average incomes. ie how much spare (or other) change do we have at the end of the day)

    This is not a useful measure of inflation (although it is a measure of purchasing power) unless you compare cpi/incomes for many countries in which case you have a comparative measure

    Without Housing and Fuel what you have is how prices are rising in a much truer measure of real inflation of the rest of the economy.

    This shows the impact of the Housing and Fuel and hence combining it with Housing and Fuel doesnt help guage overall inflation.

    Hence I prefer to strip Housing and Fuel out.

    There is one beef I do have with inflation. This is the measure of 'apples to oranges'. ie how do you account for increased value for the same price?

    To give an example. If I buy and ear of corn today it is essentially the same as an ear 10 years ago. So if you compare prices you are comparing like for like.

    If we examine cars, computers or anything manufactured this is not remotely true. Cars today may cost the same, relatively as in 1970, except now you get electric windows, higher fuel economy, air bags, ABS, electric doors etc etc

    ie you get more bang for your relative buck and you are not comparing like for like except in one way - the newer options are your only choice and you can no longer buy the 1970s car (BTW in contradiction, I believe low end models actually fill that gap)

    As a final point on inflation. In a market with higher inflation, if you have a fixed rate mortgage then property is your best bet as it holds value across inflation. People still need a place to live and unlike gold you can use property.

    BTW Gold has no more intrinsic value than paper money. It is simply a religion you;ve been brought up in to think it has real value.

  • Report this Comment On December 13, 2010, at 4:32 PM, PostScience wrote:

    I have to laugh at all the people who complain about inflation. In 2008, nationwide gas prices were over $4/gallon, now it's just under $3. Housing prices have also fallen considerably, which will help future buyers and renters. I think it's a problem of perception. People have less money, therefore they are more price sensitive.

  • Report this Comment On December 14, 2010, at 6:14 AM, TopAustrianFool wrote:

    "I have to laugh at all the people who complain about inflation. In 2008, nationwide gas prices were over $4/gallon, now it's just under $3. Housing prices have also fallen considerably, which will help future buyers and renters. I think it's a problem of perception. People have less money, therefore they are more price sensitive."

    Do you laugh at the 9.5% unemployment which is the result of inflation?

  • Report this Comment On December 14, 2010, at 6:49 AM, whereaminow wrote:

    First, you have to define the terms deflation and inflation.

    Deflation is a PERSISTENT drop in the GENERAL price level. The popping of a housing bubble is not deflation, since no matter how far it drops, it is still only one sector of the economy. America has not experienced deflation.

    Another definition of deflation is a shrinking money supply, which would lead to falling prices (it is bizarre that people recognize how a contracting money supply would lead to lower prices but they don't see how a growing money supply could lead to higher prices...)

    The problem here is that many people assume that when a bubble pops that is built on leveraging, that must mean the money supply will contract since people will default on their debts. However, this is not the case under a money printing regime, since credit just gets shuffled around. More on this takes a more careful explanation, but just know that the money supply only briefly contracted before exploding upward again.

    Inflation, in modern terms, is a PERSISTENT rise in the GENERAL price level. Good luck getting agrement on the definition of the two capitalized words. Or how to measure them.

    Originally, and for 99.999% of human history, before the central banks bought the economics profession, inflation was the ACT of debasing the currency. Search Wikipedia for John Law for the first professional inflationist. Once debasing the currency became an academic profession (the 1800s in Europe, the 1900s in America), the definition was changed. No one wants to be called a thief.

    David in Qatar

  • Report this Comment On December 14, 2010, at 6:54 AM, whereaminow wrote:

    PostScience wrote:

    <i>I have to laugh at all the people who complain about inflation. In 2008, nationwide gas prices were over $4/gallon, now it's just under $3.</i>

    True, but it was $1.81 when Obama took office in January 2009 and it just crossed $3. Since this price can't be explained away as the result of evil speculators or unspecified supply shocks, it leaves many people scratching their heads.

    However, if you understand the role of the money supply in the science of interpersonal exchanges (catallactics), then it is quite obvious that the currency has been debased, causing higher commodity prices across the boards.

    The barbarian economists of the Keynesian, MMT, and Chartalism schools would disagree, I'm sure. And the political pundits will surely blame it on the "other party."

    But it's money printing. Nothing more. Nothing less.

    David in Qatar

  • Report this Comment On December 14, 2010, at 10:25 AM, eigenvalue100 wrote:

    Thanks to zymok for clarifying some issues.

    To anybody who is interested in learning how the CPI is calculated go to bls.gov/cpi/home.htm

    There you will find lots of information, including: Common Misconceptions about the CPI. Questions and Answers.

    Of course, for anybody who is convinced that most government agencies are prone to spread misinformation and lies that won't be of any help.

    To Nick Kapur: Housing is indeed a major items, with a weight of 42% in the overall index. But this group includes not only Shelter (rents and imputed rents) but also Fuels and utilities (5%) and Household furnishings and operations (5%). So Shelter has a weight of 32%. See BLS for details.

    The weight of Shelter varies from 29% in the Detroit area to 38% the NY and SF regions (scroll down to 'RElative Importance of Components of Consumer Price Index, 2008).

    As you know there is a regional breakdown! But if you want one single number, you will be provided with a single number, but then don't complain.

    The BLS publishes hundreds of series related to the CPI. One, the core index, excludes food and energy (such as energy included in the Housing group), others exclude shelter, etc. and those subindices are readily available for anybody who would like more detailed information. Just as with data on unemployment or GDP there are is detailed information available for inflation, but there is also a national figure which makes the headlines.

    There has been some discussion in the economic literature whether asset prices should also be considered in the deliberations of policy makers (US government, FED) and should also be included in the CPI. But this is another matter. And if asset inflation were also (somehow) included in the CPI to measure inflation, then, I'm sure, there would be complaints that such an inflation measuring stick is much to encompassing. So, just be sure what kind of inflation the CPI measures and what not. Economic activity needs to be judged along many dimensions!

  • Report this Comment On December 14, 2010, at 11:23 AM, TopAustrianFool wrote:

    Nice David in Qatar...

  • Report this Comment On December 15, 2010, at 4:25 PM, AgAuMoney wrote:

    The primary issue with the CPI-U (as used to index SS benefits for inflation and to set I-Bond inflation rates) is that the formula is set and adjusted via a political process. Ostensibly the adjustments are to make it more accurately represent actual consumer prices as experienced by the typical consumer. In effect the adjustments always make the new measurement lower than the former process.

    Until that primary issue is corrected, if it can be corrected, all the discussion and debate is merely about whose political process is the preferred process for calculating the CPI.

    For more info see John Williams' Shadow Stats website at http://www.shadowstats.com/

  • Report this Comment On December 15, 2010, at 5:03 PM, LloydBraun wrote:

    The author seems adept at making empirically-baseless anecdotal whines about the CPI. Yet no hint of a solution is even suggested.

    He seems to indicate that the housing portion of the CPI should be omitted - or something like that. That sounds like a great idea if you don't pay for housing. CPI exclusively for the homeless - pure genius.

    FYI Mr. Author, there are regional CPIs that give MSA-specific CPI components. But you seem you seem to be conveniently ignorant to that fact as well as many others.

    Weak argument.

  • Report this Comment On December 15, 2010, at 5:18 PM, dtechba wrote:

    I beg to differ, fed policy influences inflation but it nowhere near controls it. There are different types of inflation and monetary policy (controlled by the fed) impacts only some of them.

    Commodity prices are being influenced mostly by speculation. Tons of evidence out there showing that. The falling dollar has some to do with it (the dollar is often the price marker for commodities) but the current increase cannot be explained by the recent fall in the dollar.

    Housing has indeed gone down as have mortgages as we have had record numbers refinancing. This should be reflected in the CPI. The increase in rent to price ratio was a sign pinted to by analysts who claimed there was a housing bubble prior to its collapse. Moreover, rents had not kept measure with mortgages so while home prices have collapsed in many places there hasn't necessarily been a corresponding collapse in rent costs.

    Monetary deflation is ongoing. The money supply is calculated by adding loan values to available cash. If I have a loan of 100 dollars and 100 dollars in hand the fed figures there is 200 dollars in supply. However, if I pay off that loan with my 100 dollars there is 100 dollars in the bank and I have nothing. effectively, the supply has dropped by 100 dollars. People are currently paying off loans like crazy with a net effect of reducing the money supply.

  • Report this Comment On December 15, 2010, at 9:39 PM, ndhosford wrote:

    The technical details of the article are probably valid. The political reason is that the the government needs to understate inflation to make its promises appear to be kept. Social security has to be effectively cut and the only way to hide it is understate inflation. For my retirement projections I made the assumption that inflation would be understated by 50%. So far that has been optimistic. When housing starts showing big increases then it will be de-emphaized and some other items that are increasing more slowly will be emphasized.

  • Report this Comment On December 16, 2010, at 3:08 PM, cpilies wrote:

    The goverment has lied about the real CPI for over 25 years.

    See the report below:

    Consumer Price Index

    October 1st, 2004

    "GOVERNMENT ECONOMIC REPORTS: THINGS YOU'VE SUSPECTED BUT WERE AFRAID TO ASK!"

    A Series Authored by Walter J. "John" Williams

    "The Consumer Price Index" (Part Four in a Series of Five)

    October 1, 2006 Update

    (September 22, 2004 Original)

    _____

    Foreword

    This installment has been updated from the original 2004 version to incorporate additional research on earlier changes to the CPI. The source for most of the information in this installment is the Bureau of Labor Statistics, which generally has been very open about its methodologies and changes to same. The BLS Web site: www.bls.gov contains descriptions of the CPI and its related methodologies. Other sources include my own analyses of the CPI data and methodological changes over the last 30 years as well as interviews with individuals involved in inflation reporting.

    ______

    Payments to Social Security Recipients Should be Double Current Levels

    Inflation, as reported by the Consumer Price Index (CPI) is understated by roughly 7% per year. This is due to recent redefinitions of the series as well as to flawed methodologies, particularly adjustments to price measures for quality changes. The concentration of this installment on the quality of government economic reports will be first on CPI series redefinition and the damages done to those dependent on accurate cost-of-living estimates, and on pending further redefinition and economic damage.

    The CPI was designed to help businesses, individuals and the government adjust their financial planning and considerations for the impact of inflation. The CPI worked reasonably well for those purposes into the early-1980s. In recent decades, however, the reporting system increasingly succumbed to pressures from miscreant politicians, who were and are intent upon stealing income from social security recipients, without ever taking the issue of reduced entitlement payments before the public or Congress for approval.

    In particular, changes made in CPI methodology during the Clinton Administration understated inflation significantly, and, through a cumulative effect with earlier changes that began in the late-Carter and early Reagan Administrations have reduced current social security payments by roughly half from where they would have been otherwise. That means Social Security checks today would be about double had the various changes not been made. In like manner, anyone involved in commerce, who relies on receiving payments adjusted for the CPI, has been similarly damaged. On the other side, if you are making payments based on the CPI (i.e., the federal government), you are making out like a bandit.

    In the original version of this background article, I noted that Social Security payments should 43% higher, but that was back in September 2004 and only adjusted for CPI changes that took place after 1993. The current estimate adjusts for methodology gimmicks introduced since 1980.

    Elements of the Consumer Price Index (CPI) had their roots in the mid-1880s, when the Bureau of Labor, later known as the Bureau of Labor Statistics (BLS), was asked by Congress to measure the impact of new tariffs on prices. It was another three decades, however, before price indices would be combined into something resembling today's CPI, a measure used then for setting wage increases for World War I shipbuilders. Although published regularly since 1921, the CPI did not come into broad acceptance and use until after World War II, when it was included in auto union contracts as a cost-of-living adjustment for wages.

    The CPI found its way not only into other union agreements, but also into most commercial contracts that required consideration of cost/price changes or inflation. The CPI also was used to adjust Social Security payments annually for changes in the cost of living, and therein lay the eventual downfall to the credibility of CPI reporting.

    Let Them Eat Hamburger

    In the early 1990s, press reports began surfacing as to how the CPI really was significantly overstating inflation. If only the CPI inflation rate could be reduced, it was argued, then entitlements, such as social security, would not increase as much each year, and that would help to bring the budget deficit under control. Behind this movement were financial luminaries Michael Boskin, then chief economist to the first Bush Administration, and Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System.

    Although the ensuing political furor killed consideration of Congressionally mandated changes in the CPI, the BLS quietly stepped forward and began changing the system, anyway, early in the Clinton Administration.

    Up until the Boskin/Greenspan agendum surfaced, the CPI was measured using the costs of a fixed basket of goods, a fairly simple and straightforward concept. The identical basket of goods would be priced at prevailing market costs for each period, and the period-to-period change in the cost of that market basket represented the rate of inflation in terms of maintaining a constant standard of living.

    The Boskin/Greenspan argument was that when steak got too expensive, the consumer would substitute hamburger for the steak, and that the inflation measure should reflect the costs tied to buying hamburger versus steak, instead of steak versus steak. Of course, replacing hamburger for steak in the calculations would reduce the inflation rate, but it represented the rate of inflation in terms of maintaining a declining standard of living. Cost of living was being replaced by the cost of survival. The old system told you how much you had to increase your income in order to keep buying steak. The new system promised you hamburger, and then dog food, perhaps, after that.

    The Boskin/Greenspan concept violated the intent and common usage of the inflation index. The CPI was considered sacrosanct within the Department of Labor, given the number of contractual relationships that were anchored to it. The CPI was one number that never was to be revised, given its widespread usage.

    Shortly after Clinton took control of the White House, however, attitudes changed. The BLS initially did not institute a new CPI measurement using a variable-basket of goods that allowed substitution of hamburger for steak, but rather tried to approximate the effect by changing the weighting of goods in the CPI fixed basket. Over a period of several years, straight arithmetic weighting of the CPI components was shifted to a geometric weighting. The Boskin/Greenspan benefit of a geometric weighting was that it automatically gave a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price.

    Once the system had been shifted fully to geometric weighting, the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third.

    The BLS publishes estimates of the effects of major methodological changes over time on the reported inflation rate (see the "Reporting Focus" section of the October 2005 Shadow Government Statistics newsletter -- available to the public in the Archives of www.shadowstats.com). Changes estimated by the BLS show roughly a 4% understatement in current annual CPI inflation versus what would have been reported using the original methodology. Adding the roughly 3% lost to geometric weighting -- most of which not included in the BLS estimates -- takes the current total CPI understatement to roughly 7%.

    There now are three major CPI measures published by the BLS, CPI for All Urban Consumers (CPI-U), CPI for Urban Wage Earners and Clerical Workers (CPI-W) and the Chained CPI-U (C-CPI-U). The CPI-U is the popularly followed inflation measure reported in the financial media. It was introduced in 1978 as a more-broadly-based version of the then existing CPI, which was renamed CPI-W. The CPI-W is used in calculating Social Security benefits. These two series tend to move together and are based on frequent price sampling, which is supposed to yield something close to an average monthly price measure by component.

    The C-CPI-U was introduced during the second Bush Administration as an alternate CPI measure. Unlike the theoretical approximation of geometric weighting to a variable, substitution-prone market basket, the C-CPI-U is a direct measure of the substitution effect. The difference in reporting is that August 2006 year-to-year inflation rates for the CPI-U and the C-CPI-U were 3.8% and 3.4%, respectively. Hence current inflation still has a 0.4% notch to be taken out of it through methodological manipulation. The C-CPI-U would not have been introduced unless there were plans to replace the current series, eventually.

    Traditional inflation rates can be estimated by adding 7.0% to the CPI-U annual growth rate (3.8% +7.0% = 10.8% as of August 2006) or by adding 7.4% to the C-CPI-U rate (3.4% + 7.4% = 10.8% as of August 2006). Graphs of alternate CPI measures can be found as follows. The CPI adjusted solely for the impact of the shift to geometric weighting is shown in the graph on the home page of www.shadowstats.com. The CPI adjusted for both the geometric weighting and earlier methodological changes is shown on the Alternate Data page, which is available as a tab at the top of the home page.

    Hedonic Thrills of Using Federally Mandated Gasoline Additives

    Aside from the changed weighting, the average person also tends to sense higher inflation than is reported by the BLS, because of hedonics, as in hedonism. Hedonics adjusts the prices of goods for the increased pleasure the consumer derives from them. That new washing machine you bought did not cost you 20% more than it would have cost you last year, because you got an offsetting 20% increase in the pleasure you derive from pushing its new electronic control buttons instead of turning that old noisy dial, according to the BLS.

    When gasoline rises 10 cents per gallon because of a federally mandated gasoline additive, the increased gasoline cost does not contribute to inflation. Instead, the 10 cents is eliminated from the CPI because of the offsetting hedonic thrills the consumer gets from breathing cleaner air. The same principle applies to federally mandated safety features in automobiles. I have not attempted to quantify the effects of questionable quality adjustments to the CPI, but they are substantial.

    Then there is "intervention analysis" in the seasonal adjustment process, when a commodity, like gasoline, goes through violent price swings. Intervention analysis is done to tone down the volatility. As a result, somehow, rising gasoline prices never seem to get fully reflected in the CPI, but the declining prices sure do.

    How Can So Many Financial Pundits Live Without Consuming Food and Energy?

    The Pollyannas on Wall Street like to play games with the CPI, too. The concept of looking at the "core" rate of inflation-net of food and energy-was developed as a way of removing short-term (as in a month or two) volatility from inflation when energy and/or food prices turned volatile. Since food and energy account for about 23% of consumer spending (as weighted in the CPI), however, related inflation cannot be ignored for long. Nonetheless, it is common to hear financial pundits cite annual "core" inflation as a way of showing how contained inflation is. Such comments are moronic and such commentators are due the appropriate respect.

    Too-Low Inflation Reporting Yields Too-High GDP Growth

    As is discussed in the final installment on GDP, part of the problem with GDP reporting is the way inflation is handled. Although the CPI is not used in the GDP calculation, there are relationships with the price deflators used in converting GDP data and growth to inflation-adjusted numbers. The more inflation is understated, the higher the inflation-adjusted rate of GDP growth that gets reported.

  • Report this Comment On December 16, 2010, at 3:50 PM, zymok wrote:

    There is no substitution of hamburger for steak in CPI calculation.

    Gasoline is not subject to hedonic quality adjustment.

    As to the 7% under-reporting, I'd really like to know how Williams arrives at that number. I'm disinclined to take on faith such an extraordinary claim from someone who is wrong on basic facts. Show me a solid derivation of this value and I will be convinced.

  • Report this Comment On December 16, 2010, at 8:07 PM, lewellen180 wrote:

    Interesting article and comments.

    My observation would be that, aside from the regional issues, the problem with housing is one of timescale.

    Many things in the CPI can - and often do - change on a relatively fast timescale. If that's something frequently purchased - such as gasoline or food - it's more of an issue than if that thing is something you buy only on occasion - such as new housing.

    Perhaps the CPI should include a temporal weighting as well to account for this type of thing.

  • Report this Comment On December 17, 2010, at 2:14 PM, cbibuld wrote:

    When I get the junk of day to day life out of my way, I'm going to seek out or create a chart of STRICTLY the food and energy portion of the CPI. The simple fact of the matter is that while one can move in with family and friends to mitigate the effect of housing, one must eat individually. Those families not living in a major metropolitan area MUST drive to work or the mall. As energy or energy products are in everything. The fluctuations in these prices better reflect the costs of living. My sense, for what it is worth, is that even without smoothing, one would see a pattern of severe inflation in life's necessities. This would seem to make the CPI a less valuable tool than the study of a food and energy index.

  • Report this Comment On December 17, 2010, at 3:09 PM, drobertus wrote:

    Housing is certainly a significant issue, but since the CPI did not reflect booming housing prices of the last decade, reporting instead the rental, but purchase, price, the decline has been similarly muted. I would personally like to see how inflation affects different demographic cohorts. The elderly consume relatively large amounts of medical services and drugs, the prices of which are increasing at roughly double digits and have for over a decade, while younger people and families are hit with increasing college and education costs. The fraction of the CPI given to these expenses varies widely by cohort in reality.

  • Report this Comment On December 17, 2010, at 5:11 PM, zymok wrote:

    For those who want to slice and dice their own CPI special index, bls.gov provides data extraction tools that make it easy to get historical CPI data for any of the measured categories and subcategories. This plus a little knowledge of Excel will let you cook up your own custom index. They also have data in several other areas related to labor.

    URL is http://www.bls.gov/data.

    Enjoy :)

  • Report this Comment On December 17, 2010, at 5:36 PM, mrwizard555 wrote:

    it's broke, but don't let them fix it.

    there are 100 fairy god senators who would just love to pick up the phone and suggest to BLS or whoever that the number needs to be tweaked for some part of their state, i mean an area of the country that is being unfairly subjected to certain statistics.

    it would be even more broken.

  • Report this Comment On December 17, 2010, at 6:08 PM, dmbeach wrote:

    There's only one problem with this analysis: It's wrong. The BLS calculates a CPI ex-shelter, and it is up a bit less than 2% year-over-year. Granted, that's a shade higher than either the full index or the "core" number, but it hardly supports a hypothesis of runaway inflation.

  • Report this Comment On December 17, 2010, at 8:14 PM, nin4086 wrote:

    Interesting discussion. I agree with zymok: what to count in CPI depends on what you want to use that number for.

    Also, secondary indicators like gold prices are reflecting the expectation of inflation and not actual inflation.

    So, Nick, you are right about the fact that housing is different but wrong about the other things.

  • Report this Comment On December 17, 2010, at 9:43 PM, jgneuw wrote:

    Cpilies has it pretty close to right while zymok is just stating the irrelevant obvious. Fact is the present admin has every incentive to understate inflation and overstate GDP. And, that is the bottomline. If BLS cannot yield the favorable nums with the current method then they will use a different statistic.

    The steak vs: hamburger argument has merit since we are not talking "consumer cost " but "consumer expenditure." And, we are also not factoring in what I call "value reduction cost" which is the deceiving phenomenon of paying the same for a product which is packaged in a slightly and perhaps unnoticed weight or volume container. This even happens with a car as more parts are more cheaply produced as in thinner body panels. For cars, all the solid state gadgets are deceiving in that they are intended to make us think we are getting more for our money. They are the cheapest parts on the car. Fact is - inflation is upon us folks, CPI or not. And, housing is the biggest artifact within the CPI. Among others, seniors on SS are being ripped off. How else can the Fed Govnt reduce SS payments without senior hysteria. ---- JG

  • Report this Comment On December 18, 2010, at 3:17 PM, maguro01 wrote:

    http://www.harpers.org/archive/2008/05/0082023

    "Numbers racket:

    Why the economy is worse than we know"

    By Kevin P. Phillips

    Skip the first paragraph. Much of the rest is a discussion of the CPI over time.

    Today many prices are increasing. Food, for example - don't look at the price, look at the package size. Clothing? Have you noticed how things don't seem to last? Stores here do direct import and know exactly what they are buying. The US trade deficit is getting larger again and is unsustainable. If this administration can't get China to decouple the yuan/dollar, or lock it with a modest advantage like Japan always did, the US will bleed out and be under IMF control in a few years like Argentina or Russia were and for similar reasons in our real Washington. If a currency pair isn't free traded, nothing else is.

    Technology can deflate prices. Cars today in general are better - more frugal with fuel, safer, less maintenance, and longer lasting than they were. Our subsidized fuel costs prevent the full benefits of the technology, though. Laptops can be bought for less than $400 that can do far more than could be bought at all not many years ago. Energy can be used far more efficiently. A couple of generations ago Americans used to use energy like setting off fireworks - there was a positive value in using/wasting it.

    Anything with a lot of labor it it here will tend to rise faster than inflation - live theatre tickets, computer programming, some medical care.

    Something increasing prices here is nimbyism and nimbyism disguised as environmentalism. Unfortunately we can't send them a bill.

  • Report this Comment On December 19, 2010, at 2:54 PM, jgneuw wrote:

    Hey magur, thanks for the reference in Harpers. That is a good article by Kevin Philips. And, "nimbyism" --- where in heck did you get that? I know "nim" is an archaic word that means to steal but nimbyism??

    You know we should get ourselves a good fleet of lawyers and file a class action against the present U.S. Admin. and its leading representative for perpetrating a continuing fraud against the people in under-reporting inflation and over-reporting GDP(whatever that is) for political purposes.

  • Report this Comment On December 19, 2010, at 7:20 PM, carload wrote:

    @jgneuw,

    nimby = 'not in my back yard'.

  • Report this Comment On December 20, 2010, at 10:33 PM, marjorum wrote:

    Inflation? Let me tell you a story. A couple of years ago I cleaned out my pantry all the waydown to the shelves and the back wall. Way in the back, under just about everything else was a 6 1/4 oz can of chunk, light tuna. I knew the can was old, but it seemed to be intact, so I made a tuna salad sandwich for lunch. There was so much tuna in the can, I had to use a fork to dig it out. Some time later I used a more recent can labeled as containing 6 oz. I poured this tuna into a strainer to let the water drain off (no fork needed). After it drained for a half hour I weighed the tuna and found only 3.4 oz. of tuna. About a year ago tuna cans were relabeled as having 5 oz. even though the can size did not change. I performed the same pouring and weighing procedure and found only 2.1 oz of tuna, a 40% decline in the can contents, but the can price went up. That is mightly expensive water.

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