Does the Government Understate Inflation?

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:

goldman-sachs-commerce-dept-charts-pce.JPG

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:

carpe-diem-gas-cpi-newcars1.jpg

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:

carpe-diem-line-chart-gas-cpi-newcars.jpg

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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6 Responses to “Does the Government Understate Inflation?”

  1. David Pearsonon 18 Jun 2008 at 6:35 am

    There are two problems with the CPI: measurement error and data series integrity. Your post deals with the first; the second is just as important.

    I argue he changes made to CPI (hedonics and subsititution) render it useless for historical analysis. Basically, comparing CPI inflation now to CPI inflation in the 1970′s and 80′s is like comparing apples and oranges. And yet, just about every day you hear an economist or Federal Reserve Board member say that today’s inflation is nothing like the 70′s, or that our real interest rates are higher than they were then.

    The BLS, ideally, should have continued to publish the old CPI alongside the new, and that way we could have a consistent basis for historical comparisons. Note that quality improvements are nothing new: the CPI never captured the quality improvements from black and white TV’s to color, from cardboard packaging to plastic; from manual to automatic transmission; etc. So why start in 1994? Because that was the year they needed to address social security COLA increases, and to do so they ruined the integrity of the CPI as a data series.

  2. Barry Ritholtzon 18 Jun 2008 at 11:36 am

    While I originally came to read your inflation discussion, I am instead forced to challenge your discussion about vehicles. As a driver and collector of old Mercedes, I am compelled to correct your factual errors about the cars.

    In 1984, the Mercedes 300 CD was the middle of MB’s three main lines. The low end was the 190 — it was the smallest of the three main lines, and while the 500 series was the bigger vehicle. The modern equivalent of the 190 is the C class — the car you recently purchased. Its currently the smallest of MB’s 3 main lines. There is also a coupe version — the CLK — but its more expensive, starting at $46k.

    Your 1984 vehicle — the turbo-diesel coupe — was the midline car. It was larger than the entry 190 vehicle (which was an ugly little thing), but smaller than the big 500 sedan. In today’s MB lineup, it would be equivalent to the 2008 to Mercedes’ E class. The 500 series of course matches up with the S class.

    The E class today starts at $51k and goes all the way up to the $86k for the AMG version. Its most commonly sold configuration is for the E350 4Matic Wagon, which starts at $56k and with options, can go to the mid-$60s. (The E320 Sedan is $52k.)

    If you really want to see inflation, look at the dimensions of all of these vehicles — The Small C is grown, as has the E and the S. All of them are bigger, faster and more expensive.

    But comparing the 300 Series coupe with the C class is Apples and Oranges. These are not the equivalent cars in the manufacturers line ups. And, they are priced accordingly.

  3. Kurt Brouweron 18 Jun 2008 at 12:02 pm

    David — I agree that CPI has changed over time, but I disagree that change is bad. It would appear you are saying CPI should never change or that each time a change is made, a separate CPI should be tracked. But that’s impossible. Given changes as outlined in the post, the BLS would have current CPI plus three different older versions to track.

    And, I really don’t see the ‘conspiracy’ side of the argument you made in this statement…’

    ‘…So why start in 1994? Because that was the year they needed to address social security COLA increases, and to do so they ruined the integrity of the CPI as a data series…’

    You write that some nameless group (‘they’) ruined CPI in order to shortchange retirees. Who was behind this change that happened in 1994, President Clinton? Why would President Clinton have wanted to shortchange retirees on Social Security? If not Clinton, then who was behind it? Nameless, faceless bureaucrats? What would have been their motivation? Was it Congress? What would Congress’ motivation have been? And, if it wanted to reduce cost of living payments, couldn’t Congress have just tied Social Security cost of living increases to wage increases?

  4. Kurt Brouweron 18 Jun 2008 at 12:18 pm

    Barry — I have to disagree on your characterization of the 300 CD as being more comparable to an E Class MB today and your contention that the 2003 C 320 would be today’s counterpart of the 190 from 1984. The dimensions of both of my cars (1984 300 CD and 2003 C 320) are very similar. Engine size, overall body dimensions, performance etc.

    By the way, I read your blog (http://bigpicture.typepad.com/) regularly and enjoy it.

  5. Barry Ritholtzon 19 Jun 2008 at 7:35 am

    Kurt — thats my point exactly! The entire line of vehicles is bigger and more expensive. If you only look at the sizes of the vehicle, you miss the entire inflation issue — in both price and size.

    Compare the entry level and mid-class vehicles then with now.

    The eighties 190 = today’s C class.
    300 Class = E Class
    300 Coupe = CLK
    500 = S class

    Speak to anyone at Mercedes USA and they will confirm this lineup matchup (I can put you in touch with people there)

    I have a 1967 230SL, and a 1986 580SL — the later car is bigger heavier faster mopre expensive than the earlier one — but they are the parallel machines.

    One other important point: In a competitive business like automobiles, you either move forward — or die. These hedonic changes that some people point to as proof of lack of inflation is (IMO) no such thing. It reflects the dynamicism of capitalism, and the inevitable progress of Humanity’s ingenuity. That we make things better faster smarter says nothing about the changing pricing of goods and services, and everything about innovation and copmpetition.

  6. Kurt Brouweron 19 Jun 2008 at 8:01 am

    Barry — In your comparison chart you have the 300 Coupe (1984 300 CD was a two-door coupe) as comparable to the CLK, not the E Class. I believe the CLK is smaller or at least lighter than the 300 CD, so it must be the exception to the trend you mentioned that makes the entire line bigger.

    Getting back to the main point of this post, which is inflation, do you think hedonic or quality adjustments make any sense in calculating inflation? If you do not agree with owners’ rent equivalent as the correct measure of housing inflation, what would be better? And, do you think the calculation should (or should not) include product substitution.

    And, finally, these changes were made over decades in various administrations. Even Bill Gross hints at a nefarious purpose for these changes which would be to reduce COLA adjustments to Social Security etc. Do you agree that this was the purpose of the adjustments? If so, who was behind it?

    Who was behind this change that happened in 1994, President Clinton? Why would President Clinton have wanted to shortchange retirees on Social Security? If not Clinton, then who was behind it? Nameless, faceless bureaucrats? What would have been their motivation? Was it Congress? What would Congress’ motivation have been? And, if it wanted to reduce cost of living payments, couldn’t Congress have just tied Social Security cost of living increases to wage increases?

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