Mark Twain once said, “There are three kinds of lies: lies, damned lies, and statistics.” I always thought that the Consumer Price Index is all three. Every month we get a number from the government telling us how much prices have risen, and every month I am quite shocked as to how ridiculously low “inflation” is reported. In the past seven years, housing and energy prices have soared. If you forget about the statistics, you can just look at the size of your new neighbor’s mortgage, your gas receipt, or your grocery bill to see significant increases. So how is it possible that the CPI we see in the media is always so low?
The answer can be found here at the California Division of Labor Statistics and Research:
Q3. Is the CPI a cost-of-living index?
A3. No, although it frequently (and mistakenly) is called a cost-of-living index. The Bureau of Labor Statistics (BLS or the Bureau) has for some time used a cost-of-living framework in making practical decisions about questions that arise in constructing the CPI. A cost-of-living index is a conceptual measurement goal, however, not a straightforward alternative to the CPI. A cost-of-living index would measure changes over time in the amount that consumers need to spend to reach a certain “utility level” or “standard of living.” … It is very difficult to determine the proper treatment of public goods, such as safety and education, and other broad concerns, such as health, water quality, and crime that would comprise a complete cost-of-living framework.
Fine, now I understand that it’s very difficult to construct a cost of living index and I suppose that’s why “almost 60 percent of the CPI covers prices that consumers pay for services ranging from airline fares to movie tickets and laundry charges“. But why do 80 million people’s incomes adjust according to the CPI if it doesn’t reflect the movement of their living expenses? How could our seniors who live on their pensions or social security funds that increase according to the CPI handle cost of living adjustments that are several times of the CPI? Should they be adjusting their spending so that 60% of their money is spent on movie tickets and airfare? Why are we using a statistic that we know is broken on something as important as the livelihoods of entire families?
The government does benefit financially in several ways by reporting a lower CPI rate. Since they adjust their wages and retirement benefits according to the number, the lower it is they less they spend. The tax brackets and exemptions are also tied to the CPI, so a smaller increase in the tax bracket means more tax revenues if most people’s wages adjusted more than the artificially low CPI. Additionally, a low CPI in the media reassures consumers that things aren’t getting more expensive and it’s okay to spend. More spending stimulates the economy, but decimates the savings rate and actually increases inflation.
I have no idea what the “true” inflation on everyday living expenditures is, but I am absolutely positive that it has been much more than 3 percent a year for the last seven years. That’s why whenever I see retirement calculators that use a historic CPI rate to estimate my future costs I tend to be skeptical. I always add at least 3% to the CPI inflation number to estimate my future costs. I am pretty sure that real inflation will hurt us next year since the Fed has cut the interest rate a whopping 0.5% and crude oil is now at an all time high. In conclusion, don’t trust the CPI numbers as a measure of inflation. In fact, don’t trust any numbers but your own because only you are familiar with your own situation and needs.
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2 comments ↓
Actually, according to standard economic models, raw measures of inflation such as what CPI is intended to be overstate the cost of living due to price substitution effects. The basic argument is that since the relative prices change, people will shift their consumption as a result of relative price changes, and so the incomes will have to increase by a smaller amount than the inflation rate for people to be just as better off. For a simple illustration, suppose the cost of air travel increases five-fold compared to the past year. Suppose that on average the consumers are compensated so that their income is now sufficient to afford the same amount of air travel as before. Will they actually continue flying as much after this compensation? Mostly likely no. Most will reduce their air travel and spend the extra money on the products with a better cost/benefit compared to air travel, and they actually will be better off. Similarly, compensating consumers for increases in the cost of gas dollar for dollar will have a similar effect because there will be people who will just get a more efficient vehicle, or drive less, and spend the remainder of cash on other things. A true cost of living index would not have this price substitution bias in it. I suppose that coming up with a true cost of living index is a much harder problem than coming up with a proper inflation index.
Another problem with CPI might be, as you highlight, is that CPI might not even measure the inflation correctly. In that case, this whole little theoretic discussion is kind of relevant since if we don’t have a proper price index to begin with. Since California and other coastal areas have been experiencing various bubbles (and busts) regularly, it is not surprising that the local consumer price index might indeed be higher than what the national CPI suggests.
[…] a year ago I wrote an article about the Consumer Price Index that made some friends say that I am a conspiracy theorist, but […]
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