Is the Consumer Price Index for Real?

December 31, 2012

People who take budgeting and retirement planning seriously are concerned about the specter of inflation raising its ugly head.

Is there a reliable measure of inflation to plan for retirement needs or to forecast whether you will meet investment goals?

The most widely reported measurement is the Consumer Price Index (CPI), a cost-of-living index calculated by the Bureau of Labor and Statistics. But there are critics who say the CPI doesn’t correspond to reality.

The index is important because it is used by the federal government to determine whether economic policies need to be modified to prevent inflation. It also is used to adjust prices used in computing real gross domestic product (GPD), an economic indicator important to investors.

In addition, cost-of-living increases in Social Security and other government programs are tied to CPI.

The Labor Bureau collects price information from 23,000 retail and service businesses concerning 80,000 consumer items. The businesses chosen are the types frequented by a sample of 14,500 families. The CPI includes sales taxes but excludes income taxes and the prices of investments, such as stocks and bonds.

There are several different CPIs, but the two most important ones are the “headline CPI,” to which cost-of-living increases in Social Security are tied, and the “core CPI,” which the Fed uses when establishing economic policy. Core CPI excludes from its sample “volatile” gas and food prices.

Overstated?

Some critics have argued that CPI overstates inflation in several ways. When the price of a product increases, consumers often substitute a lower-priced product.

The argument is that CPI doesn’t adjust to these changes in buying habits or to shifts from buying retail to buying wholesale or through discount outlets.

Increases in quality (and therefore value) are also not adequately reflected in price index calculations.

Price decreases due to technology and innovation take time to show up in the index. The Labor Bureau has made adjustments in these areas to try to address the concerns, and the adjustments have in fact resulted in lower CPI than would have been the case under the former calculation methods.

Understated?

Other critics argue that CPI is understated. Not only that, but some of these critics say that the changes the Labor Bureau has made are purposeful manipulations to understate the cost of living and that government is motivated to understate it for two big reasons:

1. Social Security and some other government payments are tied to CPI, so the lower it is, the less the government has to pay.
2. CPI deflates components used to calculate real GDP, making the economy look better than it really is and making politicians look like better stewards of the economy than they really are.

How do critics say government manipulates CPI to conceal the true cost of living? Here are a few ways:

Years ago the Labor Bureau created geometric weightings or percentages for how much particular products account for spending.

When the prices of particular types of purchases such as food, gasoline or medical care rise, the percentages for those categories are not adjusted to reflect the actual percentage of family expenditures that category represents.

The result is to greatly understate the actual effect of such price rises on a family’s true cost of living, an effect that is compounded when prices rise in a particular area steadily over many years.

Some of the measures that allegedly were adopted to avoid overstating CPI, such as taking into account substitution purchases, are easily manipulated to conceal progressive decreases in quality, critics claim.

Similarly, “hedonistic deflators” used to discount a product’s price based upon quality enhancement and technology are arbitrary and subjective, making them easy to manipulate to force CPI downward.

CPI calculates the cost of shelter (about one-third of the CPI formula) not in terms of home prices but in terms of “rental equivalent.”

But, while home prices have risen substantially over the past couple of decades, rents have not followed suit because the demand for home ownership drove down the cost of renting.

So, while “housing” costs increased substantially, the housing component of the CPI was actually suppressed.

A famous line from the Marx Brothers movie Duck Soup is “Who you gonna believe, me or your own eyes?”

Consumers and investors who question whether CPI reflects reality can identify with the insight that line suggests and may want to take price index numbers with a grain of salt when planning for the future.