Chained-CPI is not an accurate deflation gauge

 

The following article was written by Robert Barone in the May 6, 2012 Reno Gazette Journal. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director the associated AAA Insurance Company where he chairs the Investment Committee.

 

 

Chained-CPI is not an accurate deflation gauge

Circulating around the Beltway is a concept called Chained-Consumer Price Index (Chained-CPI). It is being billed as a new and “more accurate” way to measure the rate of inflation.

In an April 25th article, the editors of Bloomberg View stated that the Chained-CPI “is a more accurate gauge of U.S. inflation that would yield immediate savings … The fix to this has already been endorsed by lawmakers in both parties, the Obama administration, many economists, and a series of bipartisan deficit-reduction panels.”

According to Bloomberg View, the Chained-CPI is “a more exact measure that accounts for the substitutions consumers make when a product’s price goes up.” Remember this substitution concept, for, as you will see, it is the problem not the solution.

Currently, the most popular measure of inflation is the Consumer Price Index. The Bureau of Labor Statistics (BLS) produces several CPI measures monthly, but the one that makes the headlines is called CPI-U. In theory, CPI-U represents the buying patterns of all urban consumers.

This CPI measure is the “benchmark” that determines cost-of-living adjustments (COLAs) for a wide range of government programs, including Social Security, Medicare and government pensions. It is also widely used by the IRS in the tax code, in union contracts and in most long-term rental agreements.

The reality is that, like much of what comes out of Washington, the “Chained-CPI” concept is neither new nor more accurate. This chain-weighted concept is just another step in a series of steps that began in 1980 aimed at changing the CPI concept from one that measures the cost of maintaining “a constant standard of living” to measuring, really, not much at all, as I will explain later.

The real purpose of altering the methodology is twofold: 1. To reduce the reported increase in inflation for political reasons; and 2. To lower future federal budget costs of Social Security, Medicare and government pensions by lowering the COLA adjustments without having to have Congress vote for those or the administration sign it into law. Just note, however, what class bears the biggest burden of this – seniors and retirees.

The CPI rate of inflation reported for the year 2011 was approximately 3 percent. That was higher than what appears to be “tolerable” for America’s political class. But, we have a fairly recent concept called “core” CPI, which is the CPI-U excluding food and energy.

Both Fed chief Bernanke and Treasury Secretary Geithner believe that this is a better measure of “underlying” inflation. Apparently, they don’t believe that Americans are much impacted by the cost of petroleum products or food. I promise, however, that when the “core” CPI is higher than the CPI itself, “core” will be ignored!

If the methodology for computing the CPI-U were the same formula that was used in 1980, then the 3 percent rate of inflation reported for 2011 would have been closer to 11 percent, according to John Williams of Shadowstats.com, who follows this indicator in detail.

In 1980, the CPI measured a “standard of living,” with the price index telling us how many dollars more it would take to buy the exact same basket of items we bought in a prior period, say, last year. Below is a simple example using two goods: T-bone steaks and hamburger.

The table shows that the consumer has chosen, at current prices, to spend 50 percent of his/her budget on each item. The weighted index is $6.50. Now, assume that the price of T-bone steak rises to $12 while hamburger rises to $3.25. The table below shows that the weighted index would be $7.625.

That is, it now takes $7.625 to purchase what $6.50 used to purchase. What that says is that to maintain the “standard of living” that $6.50 used to buy now takes $7.625. So, prices have risen (i.e. inflation) by 17.3 percent [(7.625-6.5)/6.5].

We all know that when prices change, and especially if incomes are not rising as fast as prices, consumers substitute lower cost goods that usually are of lower quality. When that happens, the “standard of living” is clearly falling. The following is an example of how the Chained-CPI would significantly lower the reported inflation rate.

The table shows the same two goods, but because incomes have not risen, consumers have cut back T-bone steak to 40 percent of their budget and increased hamburger to 60 percent. As shown in the following table, the weighted index is $6.75 and the resulting reported rate of inflation is 3.8 percent [(6.75-6.50)/6.50)] rather than the 17.3 percent rate associated with maintaining a defined “standard of living” (i.e. 50 percent T-bone and 50 percent hamburger).

U.S. consumers already know that their living standard is being eroded, and that the reported rate of inflation understates reality. This has been the explanation of why. And, clearly, the “Chained-CPI” is not a “more accurate” gauge of inflation.

If you think about it, the two weighted average costs using different weights are not really comparable at all. What would you say if consumers had to substitute canned dog food for hamburger? Would you think the measure of inflation meant anything? The 3.8 percent is a math result, the product of numbers in a formula. But the numbers being used in the calculation measure different things and are not comparable. The result is that the Chained-CPI doesn’t really measure anything.

Nevertheless, the coming use of the Chained-CPI will allow reporting of much lower rates of inflation than is the reality, reducing Social Security, Medicare and government pension COLAs, all without any action on the part of Congress or the administration.

It also will distort to the upside the reporting of other economic activity where “nominal” (i.e. current dollar) indicators, such as GDP, are translated into “real” terms by deflating them with an artificially low measure of inflation.

As I’ve said in many past blogs, much of the recession is being carried on the backs of those living on fixed incomes, savers, those living off of accumulated assets and retirees. Not only do they now get near 0 percent on their savings, but now they will be further cheated out of part of the COLA adjustments that would keep them at their current living standard via their Social Security, Medicare and, if a government retiree, pension. Isn’t it wonderful how government works?

 

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