"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)
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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.
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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.
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