Kurt Brouwer June 17th, 2008
Update: This is the first in a three-part series on this question. See also Part II, Does the Government Understate Inflation? — Bill Gross Says Yes and Part III, Does the Government Understate Inflation? — Don Boudroux & Russell Roberts Say No.
The Consumer Price Index (CPI) and other governmental measures of inflation are under fire these days. Most of the action is on the side of those who claim that CPI and other inflation statistics understate the actual rate of inflation. And, when we buy gas or groceries, it seems as if the cost of living is up a lot more than 3-4%. What gives?
When it comes to our personal experience of inflation, we tend to focus on those things that have changed in price a lot as well as those things we purchase most frequently. The charts below show annual rates of inflation for different categories of things we buy. This data comes from the Department of Commerce and its Personal Consumption Expenditures (PCE) survey. Because we buy food every day and gas once or twice a week, we are much more aware of price increases in these categories and this affects our perception of overall inflation:
Source: Goldman Sachs/Department of Commerce
As these charts indicate, over the past couple of years, the cost of food and fuel have gone up much more than the overall rate of inflation. So, if we just measured just those items, the CPI or PCE or any other index would be much higher. But, these indexes are tracking a whole basket of things we use, some of which are going up in price and others (such as housing or new cars) that may be falling right now.
For example, the CPI is the most commonly-used index of inflation. The Bureau of Labor Statistics (BLS) that creates the CPI describes it as:
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
The market basket of goods covered is:
The CPI represents all goods and services purchased for consumption by the reference population…BLS has classified all expenditure items into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows:
- FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, service meals and snacks)
- HOUSING (rent of primary residence, owners’ equivalent rent, fuel oil, bedroom furniture)
- APPAREL (men’s shirts and sweaters, women’s dresses, jewelry)
- TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
- MEDICAL CARE (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
- RECREATION (televisions, pets and pet products, sports equipment, admissions);
- EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
- OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses)..
So far, I’m sure all of this makes sense. However, the magic or the mistakes come in how you allocate among these categories. As you can imagine, measuring all these categories and determining how much of each a family might use is complicated. For example, what if the cost of steak goes up, but hamburger does not? To save money, a given family buys hamburger and not steak. Should the index track the steak or should it substitute a somewhat similar food for another that has gone up in price?
Then, if you add in additional factors such as that the quality of something may be changing along with the price, the complexity of the calculation goes off the charts. Here’s an example:
In November, 1983, I bought a 1984 Mercedes 300 CD and paid about $33,000 for it. I kept that car for 19 years and bought essentially the same make and model (2003 Mercedes C 320) in December 2002. The new car is significantly better than the 1984 model because it gets better mileage, has more interior room, is much safer (air bags, traction control). Had car prices kept up with inflation over that time period, the 2003 model should have cost around $58,000. In addition, it should have been even higher in price due to the higher quality — it is a much better car.
Yet, I paid $39,500 or so for the 2003 model, an increase of 20% or roughly 1% a year. And, even at that, how should I measure the quality improvements, most of which were unavailable at any price in 1983? So, what was my personal inflation experience with car purchases over the past 20 years?
But, we buy cars infrequently and when we do buy them, we do not really factor in the quality improvements that new cars feature. For example, consider maintenance and reliability. Today, cars routinely go 40,000 miles on a set of tires. In the 1950s, a set of tires lasted 15-20,000 miles. Similar improvements have been made in brakes, engines and other areas. Back then, after 100,000 miles, a car was worn out. Today, a car with 100,000 miles on it has plenty of life left in it.
Here are two interesting charts. The first shows the average annual increase in gasoline, overall CPI and new cars for the past 30 years. The second chart displays the same information in a line chart so you can see changes year by year:
Source: Carpe Diem
Based on this chart covering the past 30 years, my experience in buying a new car a few years back was not all that unusual because the rate of increase in new car prices has been about half the overall increase in prices as measured by CPI. And, for those who think gas has gone up much more than overall inflation, they’re right. It has gone up 50% more than overall CPI. But, the big increase in gas prices did not start until 2003. Prior to that, gas prices moved up at or below the overall CPI rate:
Source: Carpe Diem
As you can see from both of these charts, fast-rising prices in one product such as gas can be partially offset by slower growth in prices of another product such as new cars. By the way, if you think our gas prices are high, see GASENFREUDE.
Whether we are talking about gas prices or food costs or even the cost of new cars, the statisticians who create the CPI try to take these into account. Whether they do it appropriately or not is a complex question. Today, many pundits, portfolio managers and others think CPI understates the true cost of inflation. And, facing soaring energy and food bills, most of us would agree that the perceived cost of living is up more than 4% in the past year. Yet, the argument that CPI understates (or overstates) inflation has been raging quietly for years. Currently, the ‘understates’ crowd has the upper hand, but 10 years ago, the ‘overstates’ crowd was dominant. Who is right?
In part two of this series (actually I just made up the Part Two bit because this post is already getting pretty long), we’ll look at those who argue that CPI understates inflation along with those who believe CPI overstates inflation. Stay tuned…
Update: Here is Part Two: Does the Government Understate Inflation? — Bill Gross Says Yes
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