PART I: INTRODUCTION
There are lies, damn lies and then there are statistics!
- Mark Twain -
Have you noticed that what you pay at the pump or the check-out counter seems to have little correlation with government inflation figures? Does it seem that prices for daily necessities are going up at a rate far greater than 2% per year? Well, the following will attempt to explain why your experience is far different than what the government is telling us. Over the past 20 plus years, the government has made several “adjustments” to the primary measurement of inflation known as the Consumer Price Index (CPI). In this article, I will explain what those adjustments are and why they have resulted in the significant understatement of the CPI. If I were a lawyer (which I’m not) and if I were prosecuting the government, the first steps I would need to take is to establish that the government, and more specifically the Bureau of Labor Statistics (BLS), has both the means and motive to manipulate inflation statistics.
PART II: MOTIVE FOR MANIPULATING THE CPI
Several decades ago, US citizens became wise to the fact that the US government was willing to inflate the money supply which leads to price inflation in order to cover up budget deficits. So in order to keep the government in check and limit their ability to create inflation, the CPI was created to adjust future government liabilities for inflation.
Currently, the US government has the largest pension plan in the world and is the largest employer in the world. Every single pension payment and practically every employee salary of the US Government is adjusted according to the CPI. Furthermore, Social Security payments are adjusted by the CPI. Therefore, if the government wants to reduce its current expenses and its future liabilities, (so that it can spend more money on pet projects that are more likely to generate votes) understating the CPI is one of the most effective means of doing so. John Williams, founder of Shadowstats.com, states that “Social Security checks today would be double had the various changes [to the CPI calculation] not been made.” Furthermore, every government retiree would be receiving higher pension payments and current employees would be receiving higher salaries.
PART III: MEANS FOR MANIPULATING THE CPI
So the motive is clear. Put aside less money today for current salaries and liabilities and future obligations so that the government can spend more on projects that will get votes now. Now that we’ve established a motive, the next step is to establish the means of manipulating the CPI. Does the BLS have the means to manipulate the CPI data? Unfortunately, the answer is YES. The following are seven different adjustments made by the BLS to the CPI calculation which invariably suppresses the inflation figures. For each “Adjustment”, I’ll start with a simple explanation of the adjustment, then provide an example or illustration and finally, I’ll add my own editorial comments as to why the adjustment negatively impacts the CPI.
Adjustement#1: Geometric weightings What is it? Many years ago (I think it was around 1996) the BLS created weightings for each consumer product to determine how much it accounted for the average person’s annual spending. These weightings are reset each year to their original value regardless of how much a particular product increases in price. For example, Gasoline is 5.215% of the CPI calculation and even if Gasoline increases 10-fold, it will never account for more than 5.215% of the calculation.
Illustration: Let’s continue with energy as an example. Gasoline is approximately 5% of the CPI calculation. Assume the price of gas doubles in year one (don’t have to use too much imagination on this one) but the price of everything else stays exactly the same. You would think that in year 2, gas’s price factor in calculating the CPI would be 10% - but not with geometric weighting, because the factor is set back to 5% after year 1. Now assume that in year 2 the price doubles again and the price of everything else stays level. In reality, the consumer would experience price inflation of 10% but using the BLS’s geometric weighting, reported price inflation would only be 5% because the weightings were reset. The result would be that reported inflation would be half that of reality.
The rub…. The problem with using geometric weightings is that it assumes that the prices of all things are equally elastic which they are not. The best example is Health care which is extremely inelastic. From 2000 - 2007, healthcare insurance costs rose 114% compared to the CPI which went up just 25%. (Source: Kaiser/HRET Survey of Employer-Sponsored Health Benefits). (BTW, Health Insurance costs only account for 0.537% of the CPI calculation. And no, I didn’t misplace a decimal point, according to the BLS, only ½ of 1% of your annual expenditures goes towards health insurance.)
The other huge problem with geometric weightings is that it totally eliminates the compounding effect of price increases. Back to our gas example. Assume the price of gas doubles every year for five years while the price of everything else stays exactly the same. In year 5, the CPI using arithmetic weighting would be 50% due to the compounding effect of gas doubling each year. But using geometric weighting, year 5 inflation would be a mere 5%. So as time goes on and weightings are continually reset, the reported inflation number for items whose price outpaces the CPI will continue to be further and further from the actual experience of US consumers.
Adjustment#2: Substitution bias What is it? The government assumes that an individual will substitute similar items for each other if one of the items becomes more expensive.
Illustration: Assume that the government makes the subjective decision that steak and chicken are interchangeable. So as the price of beef goes up, people will eat less steak and more chicken so they substitute chicken for steak.
The rub… First, who is the government to say that chicken and beef are equal or any other two food items for that matter? The CPI is supposed to measure the cost to maintain the same standard of living – not a substituted standard of living. What keeps them from saying that steak and ground beef aren’t equivalent? While they cannot directly substitute steak for ground beef, they could do it progressively. Let’s say that in one year that the price of steak skyrockets so they decide that chicken is an appropriate substitute for steak. Then a few years later, the price of chicken shoots up so they decide that hamburger is an appropriate substitute for chicken. While no one could reasonably make the case that steak and ground beef are equivalents, the case could be made that chicken is a substitute for steak and the case could be made that ground beef is a substitute for chicken. So gradually they can get there.
Adjustment #3: Owner’s Equivalent Rent What is it? In order to calculate the cost of housing, the government uses what is called a rental equivalent which is basically what it would cost a homeowner to rent his or her home.
Illustration: In this decade, home prices have risen 87% while rents have largely remained flat. But the CPI does not use the increased cost of a home but rather the cost to rent the home so this component of the CPI has been severely understated. Since shelter accounts for 32.6% of the CPI formula, you would think it would be important to get this right.
The rub…. The problem with using Rent instead of actual home prices is that as home ownership became more prevalent driving up the demand and prices for housing, it actually drove down the cost of renting since the demand for rental units declined. So while “housing” costs increased substantially, the housing component of the CPI was actually suppressed – the exact opposite of reality.
Adjustment#4: Hedonic Adjustments What is it? Essentially, the government can arbitrarily decide how much a product improvement is worth to the consumer and discount the product’s price for the value-added benefits of the improvement.
Illustration: Let’s say you bought a Honda accord in 2006 for $25,000 that was not equipped with side curtain airbags. In 2007, the exact same Accord is now sold with side curtain airbags and cost $27,000. You might say that the price went up 8% but the government would say that you are wrong. The government would look at the new Accord and decide that a car with side curtain airbags is more valuable than one without. From there, they would subjectively calculate how much more it is worth. They may conclude that there is a 1% chance that the new airbags will save your life and that the average human life is worth $1M. Therefore, the new airbags are a value-added feature to the car worth $10,000 (1% x $1M). And since the car is worth $10k more with the side airbags, but only costs $2k more, the price of the vehicle actually depreciated $8k.
The rub…. This adjustment is by far the most egregious one of the lot. Essentially, the government is getting away with offsetting CPI with progress. Our economy should progress. Manufactures should produce better products each year. This year’s computer should be faster than last year’s. This year’s TV should have a better picture than last year’s. But the government is essentially offsetting improvements in technology by discounting the CPI in line with their subjective hedonic adjustments.
Adjustment#5: Impact of new product launches What is it? Whenever a new product comes out, it is priced at a premium and then it is discounted significantly in the first few years of production. If the BLS adds a product that just came to market as soon as it is launched, the price of the product will eventually come down bringing inflation down with it.
Illustration: Take Apple’s iPhone. When if first came out, it sold for nearly $500. In less than one year the price has fallen to $300 – a 40% price decline.
The rub… I have no idea if the BLS implements this tactic or what impact it would have on the CPI. I just know that every time the CPI report comes out, there is a huge price decline in electronics.
Adjustment#6: Seasonal Adjustments What is it? Simply, the CPI seeks to smooth out seasonal price spikes in products.
Example: Orange juice prices spike in the summer, heating oil prices spike in the winter, ect, ect. Therefore, the BLS doesn’t want monthly inflation data to spike in reaction to price spikes, so they smooth out the data.
The rub… Can not the marketplace figure this out on their own? What is the need to smooth out prices especially when seasonal goods only make up a small part of the CPI calculation? Technically, this adjustment should have no impact on the long-term calculation of the CPI, but it wouldn’t surprise me if the BLS found a way to use it to shave a few points here and there.
Adjustment#7: Focus on Core CPI What is it? Core CPI is Headline CPI minus food and energy prices (you know, those nagging daily necessities). While government pensions and social security are adjusted according to Headline CPI, the Federal Reserve uses the Core CPI as its preferred measure of inflation when determining monetary policy.
History: During the 1970’s, the government started reporting Core CPI because energy and food prices were deemed “too volatile”. Of course, the reason they were too volatile is because the dollar collapsed in value because the FED printed too many dollars to fund foreign wars and other government programs. Personally, I think it is asinine that anyone pays attention to the core CPI. It would be simple to create a mean reversion calculation for food and energy that would smooth out price volatility.
The rub…. Technically, this is not an “adjustment” but rather a point of emphasis, but there are two significant issues I have with the government’s emphasis on Core Inflation versus Headline Inflation. First, it is more difficult for them to manipulate food and energy prices. The government likes to report Core CPI because they know they can hedonically adjust non-core figures but they cannot apply these subjective adjustments to food and energy. Last year’s burger is no different than this year’s. The second and much larger issue is the impact of non-core prices on those least able to deal with rising prices. Rising food and energy costs have a much bigger impact per capita on low-income households and retirees. My 89-year grandmother doesn’t spend much on electronics, clothing or housing, but nearly all of her expenditures go towards energy (gas and utilities) and food. I am surprised that retirees are not being far more vocal about the impact of inflation on their livelihood.
PART IV: CONCLUSION
The government’s effective immunity from bankruptcy can be found in two separate but related governmental powers: 1) the government controls the money supply, meaning it controls the degree of inflation; and 2)the government also controls the official inflation indexes.
- Daniel Amerman -
I’ve established the government has both the means and motive to manipulate the CPI in its favor which has resulted in the gross understatement of reported inflation over the past couple of decades. Finally, I would like to take a hard look at the actual data I compiled a few years ago and compare non-government inflation figures to the government figures which provides compelling evidence to support my thesis.
| Price Index | Increase from 12/31/2001 – 12/31/2007 |
| CRB Commodity Index | 149.8% |
| CRB Energy Sub-Index | 302.8% |
| CRB Foodstuffs | 64.2% |
| Home Prices | 66.1% |
| Health Care Insurance | 78.4% |
| PPI – Intermediate Goods | 41.4% |
| PPI - Finished | 25.5% |
| CPI | 18.9% |
| Core CPI | 13.1% |
Sources: CRB Commodity Index, Energy Sub-index and Foodstuffs – Commodity Research Bureau. Home Prices – S&P/Case Shiller Home Price Index Health Care Insurance - Kaiser/HRET Survey of Employer-Sponsored Health Benefits PPI and CPI – Bureau of Labor Statistics (A tremendous resource regarding the topic of government manipulation of the CPI is a website founded by John Williams – Shadowstats.com. Williams reverse engineers the current inflation data to calculate the CPI without all the adjustments. He is essentially calculating it as it was done in the 1970’s. According to Williams, inflation according to the original CPI is running in excess of 11% YOY.) While the prices of the daily necessities such as food, energy, housing and healthcare have all increased anywhere from 60 – 300% over the past six years, the government figure used by the Federal Reserve to create monetary policy is a measly 13%. The most telling disparity is the difference in prices throughout the supply chain. Notice how PPI – Intermediate Goods is almost three times that of the Core CPI. Each layer of reporting is subject to more and more manipulation therefore the prices are further suppressed. It is apparent that the Government’s calculation of the CPI is far different than that of the experience of the average US citizen. Unfortunately, the CPI lie hits hardest those who can least afford it. Low-income persons who spend the majority of their income on energy and food or elderly persons who are living on a fixed income are financially crippled by rising prices. As an investor you need to understand the reason why the government must inflate the economy and why they lie about it. Over the past couple of decades, our country has operated huge deficits (both trade and budge) amassing enormous debts (this year alone the Governments budget deficit is suppose to top $500B). There are only two ways for a government to finance deficit spending – taxes and/or inflation. The current funding method is debt, but debt is nothing more than deferred taxes or inflation. Taxation is too unpopular and can be self-defeating so inflation is the only plausible way for our government to bail itself out of the current hole it is in. US Inflationary policy will continue – it has too. The government and the Federal Reserve have a fiduciary responsibility to the US populace to control inflation which puts them in a bind. Since inflation is the unintended consequence of irresponsible government spending and since they are root cause of the inflationary mess, it is difficult for them to admit responsibility much less find viable solutions to the problem. So they lie about it. The government and the Federal Reserve had no intention creating inflation, but they did and now they either have to come clean or lie about it. Given the prideful nature our nation’s top elected officials and bankers, I’m compelled to believe that they find it easier to manipulate the data and lie about inflation than to admit responsibility.