Why Is "Official Inflation" So Disconnected from Real People's Household Expenses?

The more you learn about personal finance, the more complicated your questions are likely to get. But never fear: Hosts Robert Brokamp and Alison Southwick named their podcast Motley Fool Answers for a reason, and the Oct. 29 episode -- the monthly mailbag show -- the co hosts will tackle a whole bunch of money conundrums with a bit of help from Motley Fool Wealth Management Director of Financial Planning Megan Brinsfield, CPA, CFP, and all-around fine human being.

In this segment, they tackle a question that most of us have probably asked ourselves at one time or another: Why do the inflation figures reported by the number-crunchers in Washington seem so low, when it's so obvious to anyone with a job and bills to pay that our expenses are rising faster? Turns out the Consumer Price Index is both more complicated than that, and less apt to reflect how you see your biggest expenses.

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This video was recorded on Oct. 29, 2019.

Alison Southwick: The next question comes from Ahmed. "If healthcare costs have tripled, college tuition has skyrocketed, and housing has become impossibly expensive, then what kind of inflation is the Consumer Price Index actually measuring?"

Robert Brokamp: That's an interesting, complicated, and controversial question, and the more I dug into it, the more I realized, "Boy, this is complicated!" The point you're making is if you look at the current reading for the CPI, which is inflation, generally speaking, it's only 1.7%, so it's basically nothing. Yet we keep reading about how all these other costs are going up. 

Like I said, it's complicated. If you want to understand it, you could start by reading, "The Bureau of Labor Statistics, Handbook of Methods," which is 107 pages long. I didn't get through it all, so I'm going to try to sum up...

Southwick: I'm sure you tried, though. 

Brokamp: ... sum up what I learned. The first thing you have to understand is that the CPI measures, basically, a basket of goods. What the average, typical American household spends money on. First of all, to figure that out, they do a bunch of surveys and there's a two-year lag on how they determine the basket of goods. 

And what gets incorporated is how our spending changes, so one obvious example is to look back like 20 years ago and think, "We didn't have smartphones. Now everyone buys a smartphone. They have to get a data plan. They buy their apps and all that stuff." That was not an expense that was in the basket of goods 20 years ago. So every couple of years the folks at the Bureau of Labor Statistics have to fiddle around with this basket of goods so they can do some sort of an apples-to-apples comparison from year to year.

But then they also have to adjust for the quality of the goods. Again, think of your smartphone. You can't really compare the price of the first iPhone to the current iPhone because the current iPhone has more memory. It has a better battery. It has a better camera, so they have to adjust for quality for what they call "hedonic adjustments."

So as you can see, the whole idea of the CPI is, to a certain degree, like economic hocus-pocus to come up with an actual number and the more you dig into it, the more you realize, really, that it's not reflective of the actual spending year-to-year of what you may see in your own household. To address the specific things that he mentioned, you have to look at the weightings of those items in the CPI.

Let's start with college. In the current CPI, education and communication makes up 6.5% of it and college tuition is only 1.6% of it. You can see how college tuition could skyrocket, but it's not going to really affect the CPI so much. 

Healthcare -- when you look at healthcare and medical care -- they're only measuring the out-of-pocket expenses, so it's not total insurance. It doesn't factor in what Medicare has to pay or what your employer is paying. It's just your out-of-pocket expenses, and that only makes up 8.6% of the CPI. So again, it's not a big component, so you can see how healthcare can keep going up, but it doesn't necessarily have a big weighting in the CPI.

The biggest one is housing. How do they calculate housing in the CPI? Well, rent is part of it. And this, again, is where it gets kind of funky. Homeowners -- they figure a home is part investment and part consumption and they strip out all the investment part. So if you put the down payment, if you're improving the house, closing costs; none of the that is incorporated in the CPI. Basically they calculate an implied rent that someone who owns the house would have to pay to live in the house. Again, you're getting very theoretical. It's not what's really reflected in the pocketbook of the average American. 

The bottom line is the CPI is fine for economists. It certainly suggests a hint of where prices are going, but if you look at it from an individual basis from household to household, it's not really a very accurate reflection of how someone's budget changes from year to year. 

Megan Brinsfield: I thought you were making economists proud until you used the phrase "hocus-pocus." 

Brokamp: Here's the deal. The more I dug into it, the more impressed I was with it like all the things that they try to do. They use examples that at some point, maybe, the typical suit was a two piece suit, but then later on the typical suit is a three-piece suit. Well, you can't compare the price of the suits. You have to make an adjustment. And what if they're different fabrics? So they pick out the different fabrics.

Southwick: What about men's hats? No one wears a men's fedora anymore.

Brokamp: Exactly. 

Southwick: Why, we're going to hell in a handbag. 

Brokamp: Some people will look at it and will claim basically conspiracy theory because a lot of what the government does is based on the Consumer Price Index. For example, Social Security benefits. And if they can hold down that CPI, they don't have to pay so much in Social Security. I don't think that's the case. I think the Bureau of Labor Statistics is just trying to tackle a very complicated problem.

Brinsfield: I hope that they have meetings between economists, there, that are like, "All right, we're talking about suits today. We need to nail this down."

Southwick: I'll bet they have all the meetings.

Brokamp: All the meetings.