Friday, September 05, 2008

Misconceptions and Myths About the CPI

WASHINGTON (MarketWatch) -- The U.S. government has been understating inflation, which has led investors to misprice stocks, bonds and real estate, noted bond-fund manager Bill Gross said Thursday. The real problem is not that the government publishes dubious numbers but that investors believe them and make decisions based upon them, he said.

A recent comment on Carpe Diem: "To change the definition of CPI to erase the effects of inflation is not only disingenuous, but outright fraud."

From the recent BLS Study "Addressing Misconceptions About the Consumer Price Index" written by John Greenlees and Robert McClelland, research economists in the BLS Division of Price and Index Number Research:


A number of longstanding myths regarding the Consumer Price Index and its methods of construction continue to circulate; this article attempts to address some of the misconceptions, with an eye toward increasing public understanding of this key economic indicator.

Within the past several years, commentary on the CPI has extended well beyond the circle of economists, statisticians, and public officials. The strongest criticism of BLS methodology has not been concentrated in a single profession, academic discipline, or political group, but comes instead from an array of investment advisers, bloggers, magazine writers, and others in the popular press. Also, whereas in the past the CPI frequently was held to be overstating inflation, recent criticism has focused on supposed downward biases.

Conclusions:

1. It is a myth that the BLS reduced the growth rate of the CPI by assuming that hamburger is substituted for steak.

2. It is a myth that the use of hedonic quality adjustment has substantially reduced the growth rate of the CPI.

3. It is a myth that the 1983 adoption of owner’s equivalent rent systematically reduced the growth rate of the CPI shelter index.

4. It is a myth that Social Security payments are updated by a CPI that does not include food or energy.

Each of the improvements made to the CPI over the years is based on sound economic theory and years of research by academicians and BLS economists. The methods continue to be reviewed by outside commissions and advisory panels, and they are widely used by statistical agencies of other nations.

Finally, the CPI is not, and can never be, a perfect index. Moreover, all of the topics raised in the recent commentary on the CPI—including the methods for dealing with consumer substitution, quality change, and owner-occupied housing—are critically important to the accuracy of the index. The very existence of the CPI methodological changes discussed here attests to the fact that the BLS must always be working to enhance the index. The BLS benefits from the work of academics and others who identify ways in which the CPI can be improved. The BLS also benefits when the public understands how the CPI is constructed and what the index’s strengths and limitations are. It is hoped that this article will help increase that public understanding.


21 Comments:

At 9/05/2008 4:15 AM, Anonymous Anonymous said...

"Each of the improvements made to the CPI over the years is based on sound economic theory and years of research by academicians and BLS economists."


academicians?? Let's get the governement scienticians to work on it too, that way we'll know it's really legit.

 
At 9/05/2008 4:29 AM, Blogger Rebecca Wilder said...

Thanks for the reference - I will definitely read the paper. You know, I wish that people like Bill Gross (PIMCO) would read this; they get a lot of press time, and confuse the public with their obvious misrepresentations (and lack of understanding) of economic issues like inflation and the CPI.

 
At 9/05/2008 6:55 AM, Blogger Walt G. said...

I think the biggest misconception is that people can use the CPI for their personal finances. The CPI might be great for policymakers to make national fiscal adjustments, but it is pretty useless for the consumer to use to make everyday decisions. A perfect example of a CPI index that does not apply to any individual is core inflation. Core inflation does not include food or energy. Unless you live in a cave and hunt for your food and burn wood for your heat, who does not have food or fuel expenses?

Personal variances in spending habits are just too large for the CPI to work at the individual level. Want to know what your Social Security cost-of-living raise will be next year? The CPI is great. Want to know if you can safely retire when you are 50 years old? You better not use the CPI—do your own analysis to keep from eating dog food when you are 70.

 
At 9/05/2008 7:12 AM, Anonymous Machiavelli999 said...

walt g,

The core CPI is used because it is most predictive of future inflation and therefore is the best tool for making monetary policy decisions. The next few month will actually demonstrate the point.

The next few month will probably show negative headline PPI and CPI numbers, but the core rates will show that we are not in a deflationary environment. Now, if the policymakers only paid attention the headline numbers, they might think (from the PPI and CPI numbers we will get soon) that interest rates should be set to 0%.

The fact of the matter is that inflation in food & energy over the past has not been driven by poor monetary policy but by strong growth from emerging markets. And the recent fall in commodity prices is a leading indicator of the slowdown we are likely to see in emerging markets.

 
At 9/05/2008 7:30 AM, Anonymous Don Lloyd said...

Quality adjustments for a price inflation index make no sense at all.

To see this, pick one good in the index and increase its 'quality' by 10% for one year over the previous year. Now experimentally increase the 'quality' of every other good in the index so that eventually all of the relative prices of all the goods in the index end up unchanged with respect to the previous year. With no change in the population characteristics or in the quantity of money, all of the actual prices will end up unchanged from one year to the next, i.e. there is no price inflation or deflation.

The increases in the 'quality' of every good has not produced a price deflation, as the quality-adjusters would have you believe, but rather an increase in the subjective standard of living. This is entirely different than the cost of living, which in this case would be unchanged.

Regards, Don

 
At 9/05/2008 8:46 AM, Anonymous Anonymous said...

"Core inflation does not include food or energy. Unless you live in a cave and hunt for your food and burn wood for your heat, who does not have food or fuel expenses?"

Rising food or energy costs will eventually raise core cpi prices.

 
At 9/05/2008 8:47 AM, Blogger Robert said...

Barry Ritholz et al. have been banging this "cpi is a fraud" drum for a while.

 
At 9/05/2008 9:24 AM, Anonymous QT said...

Walt g,

I think you have hit on the reason most people believe that CPI understates inflation. While it is very useful to exclude prices that are extremely volatile so that one can make correct decisions on monetary policy, the average person sees a disconnect between core CPI and what they are experiencing as a consumer.

CPI was not intended as a practical decision making tool for consumers. Look forward to reading this article.

 
At 9/05/2008 9:24 AM, Blogger Walt G. said...

Machiavelli999,

I agree the CPI is useful for policy decisions at the national level, or for figuring out wages pegged to that index. Many people, however, attempt to use it for their personal finances; it does not work well for that--especially for long-term fixed incomes.

Personally, I would not use a 3% annual inflation factor for a 30-year retirement and expect to retain my purchasing power. I think too many people attempt to use the historical CPI index because it is so highly publicized and easy to use. You really have to spend some time and personalize your financial situation for an accurate measurement. Accordingly, I doubt that the CPI really has much relevance or validity for the majority of people who read this blog other than conversation around the water cooler at work.

 
At 9/05/2008 10:13 AM, Blogger Walt G. said...

qt,

I had a poster on this blog a few months ago who called me a liar and stupid when I stated my personal inflation rate was much higher than the CPI. I’ve tracked my spending in 14 categories for the last few years, so I can document my personal rates in each category. What I don’t do, and I guess could, is figure out the ratio of my expenses in each category to my total income, but I’m anal enough already.

I’m just saying that people should make personal decisions using relevant data and not something they heard on yesterday’s news. With Excel and other common software, it’s not really that big of a deal to initially set up, and it only takes a couple minutes a month after that to maintain. I would rather hold myself accountable for my decisions than blame the government when everything goes to hell.

 
At 9/05/2008 11:28 AM, Blogger Carlos said...

Off-topic: Obama is plummeting in Intrade right now 4.3 points and getting 55.7.

Mccain now has 44.7 points

 
At 9/05/2008 1:41 PM, Anonymous QT said...

Walt g,

Took some of the courses toward Certified Financial Planner. They used 4% inflation as a thumbnail and recommended tracking actual expenses using exactly the same approach as you describe tracking expenses in different categories and as a percentage of total expenses.

Completely agree that the actuals give a far more complete picture than the news and allow one to spot trends in spending as well as set goals, for example, for retirement or an emergency fund in case of illness/job loss.

Sometimes, people do find actuals difficult to believe but that is largely because many people do not have any handle on how they spend their money. If someone has documented their expenses, you can't really disprove that although some costs can vary regionally ie. electricity costs in Canada vs. the U.S. or even between different states.

If you don't set goals and objectives in your personal finances, how will you achieve financial independence in retirement?

We set goals around every other aspect of life such as fitness, education, weight loss, career. Why is finance so different when a computer makes it so easy to manage information?

I consider you to be one of the best posters on this blog. Personally, I look forward to your postings which are always well-informed, pragmatic, well-reasoned, and well written. I hope that I will measure up to your bootstraps in time. I still have a lot to learn.

 
At 9/05/2008 2:20 PM, Anonymous One Lefty Fool... said...

> Unless you live in a cave and hunt for your food and burn wood for your heat

You got heat?

You lucky bastard!

Thanks to Bush, I got nothin'!


:oP

 
At 9/05/2008 2:26 PM, Blogger OBloodyHell said...

> I’m just saying that people should make personal decisions using relevant data and not something they heard on yesterday’s news. With Excel and other common software, it’s not really that big of a deal to initially set up, and it only takes a couple minutes a month after that to maintain.

Walt, that's too much work for most of the cud-chewers.

Hell, half the country can't be bothered to get *any* of their information from a source other than the MSMs.

And you want them to actually produce their own personal data?!?

***HA*** !!

;-)

 
At 9/05/2008 2:54 PM, Blogger the buggy professor said...

This is a remarkable document, put out by the BLS, that you linked to, Mark. Thank you. It is impressively written --- clear, to the point, and alway informative, not least thanks to numerous simple examples.

1) Walt and others, who naturally are concerned with the prices they as household members (maybe the only income-earner in them), won't find their own individual experiences mirrored in the thousands of indexes that the BLS puts out monthly, but pp. 12-15 clearly confront the problems of tracked inflation in those indexes --- especially (core) CPI-U vs. headline CPI, the former excluding volatile energy and prices --- and do as good a job as can be humanly expected to explain that gap.

2) The two authors even deal with the social psychological finding --- underscored in hundreds of experimental studies --- that people are subject to "loss-aversion" from a given status-quo that they frame in their own minds.

Meaning?

Meaning that a $100 increase in the price of oranges in 2007 would be less appreciated than the sense of loss entailed by a $100 rise in orange-prices in the same year.

I add that this kind of psychological information, now more widely used by economists --- especially since Daniel Kahneman of Princeton won the Nobel prize for his pathbreaking work (along with, alas, the deceased A. Tversky) --- even if they are still a minority and flourish mainly in behavioral economics.

3) Here is another example relevant to the last few months.

Oil prices rose dramatically in the spring, surging about 30% in just three months or so . . . virtually all of the rise, contrary to mainstream economic theory, due to speculators operating in future markets --- or so, Alan Greenspan, the former head of the Fed with access to all the Fed's numerous reports (those of the BEA and BLS too), explictly said in an Aug. 11 2008 interview with the Financial Times.

That 30% upward burst was more highly resented than the virtually equivalent decline in less than two months has been appreciated by consumers.

That is how people respond to real events.

Fortunately, as oil prices have risen steadily since 2000 or so, people have at least begun to adjust their driving habits, purchase less gas-guzzling vehicle, car-pool, use public transportation, or walk or ride a bicycle.

........

4) Those who think the BLS and BEA have been manipulating price rises for political reasons will be disappointed by the report, whose authors directly tackle this conspiratorial claim.

Three convincing arguments emerge:

First, the US CPI has been higher by 50% since 1999 than all other 6 major industrial countries' individual CPI's (good list, on p. 13, I believe)

Second, contrary to the urban myth, Social Security payments and tax adjustments are not made by use of the (core)CPI-U --- which ignores volatile energy and food prices --- but instead are based on CPI-W that includes them.

Third, there is no humanly possible way to weight all the price rises, decreases, or no-changes in a vast index that takes into account the buying power and buying habits of different Americans, according to different income categories and where they live and how.

Urban residents in San Francisco or Manhattan or Chicago --- who have good public transportation available and find parking expensive --- haven't been bothered nearly as much the last three or four years by rising gasoline prices as have residents of greater Los Angeles or Houston.

Similarly, the top 20% income earners haven't stopped buy expensive gas-guzzling Mercedes or Lexuses, whereas lots of Americans in the income-quintiles below that one have in large number no doubt either considered selling their gas-guzzlers for better mileage vehicles, or done so, or found car-pooling or other ways to deal with the pocket-book pinch of higher gasoline prices.

.....

Michael Gordon, AKA, the buggy professor

 
At 9/05/2008 3:09 PM, Anonymous Anonymous said...

I would be more apt to believe Bill Gross and others on this since they are people that put real money to work and would be in a better position to observe how misleading some of these economic indicators are as opposed to someone in academia. Keep in mind that PIMCO also conducts a large amount of on the ground analysis to get a better feel for inflation trends.

 
At 9/05/2008 3:28 PM, Blogger Walt G. said...

qt,

I appreciate the compliment. I almost entered the financial field out of high school; I was even registered in a CPA program, but I decided to just work a year at a GM plant. The allure of the big bucks—I never left.

I think a 4% inflation factor is a much more conservative and realistic estimate, but most automatic Internet planners use 3%. It’s interesting to see how much faster 1% more inflation and a 1% or 2% less return on investment impacts how long your retirement savings will last. I would not recommend any particular free Internet retirement planner, but they are useful for a rough estimate of how inflation eats away purchasing power of a fixed income over time.

Obloodyhell,

I know most people do not want to take the time to track their spending, but it takes only an hour or so to set up and just a couple minutes a month to update. It’s easy. It’s important.

I am always blown away at the amount of time people will spend to research and save a couple hundred dollars on a big-screen TV while at the same time ignoring their overall current and future financial condition :)

buggy professor

You’re always a pleasure to read. Here’s a real-world example of the CPI at work. Our quarterly General Motors’ cost-of-living wage increase is pegged to the CPI-W minus medical expenses. We received a 68-cents-per-hour raise starting September 1 for the previous three-month period. This compares to just $2.03 for the entire four–year period of September 2003 to September 2007 using the same formula. That’s some whopper inflation: Isn’t it? I feel sorry for those who do not have inflation-adjusted paychecks.

Professor Perry: Sorry to get sidetracked on your blog, but the article was excellent and informative. I see you are at almost a million visits on your blog: Keep up the good work.

 
At 9/05/2008 3:33 PM, Anonymous QT said...

"Believe"?

The words we use are very important in telling us how we think and how we make judgements.

Unless you actually understand the concepts under discussion and the basis for Bill Gross' interpretation, you are only going on your gut feeling toward Bill Gross ie. do I like and trust this guy?

In our society, we often make judgements based on our attitude toward the speaker. Unfortunately, trust is sometimes not the most accurate yardstick for evaluating information. We are really trusting that someone else has looked at the data in an unbiased way...then again, he might also have taken someone else's word for it.

This report actually provides you with an opportunity to learn more about the methodology of CPI and helps give you information to make up your own mind rather than just taking someone's word for it.

 
At 9/06/2008 9:13 AM, Blogger juandos said...

"Thanks to Bush, I got nothin'!"...

Hmmm, sounds like the rantings of a community organizer I've heard recently...

"The increases in the 'quality' of every good has not produced a price deflation, as the quality-adjusters would have you believe, but rather an increase in the subjective standard of living"...

Hmmm, interesting point but how does that explain the downward costs of electronic items such as those vastly improved televisions, computers, and cell phones for instance?

Or am I mixing apples and oranges here?

 
At 9/08/2008 5:42 PM, Blogger OBloodyHell said...

> It’s easy. It’s important.

I don't disagree as to it being worth the trouble. I said you're talking against Human Nature. Most people can't(won't) budget for the next month. This is part of the reason for Social Security.

And I'd have no problem with a goverenment mandated retirement program (or with government mandated health insurance).

I have a problem with the idea of the government running the programs in question.

The idea that you have to place a percentage of your income into a controlled-risk environment (until your assets are adequate to support you independently, at least, via ROA), that notion, I have no problems with.

 
At 9/08/2008 5:46 PM, Blogger OBloodyHell said...

> I am always blown away at the amount of time people will spend to research and save a couple hundred dollars on a big-screen TV

Dude, there are people out there willing to drive across town to save 50 cents on a can of beans. People are wired strangely. "Penny Wise and Pound Foolish" is not just an axiom, it's Human Nature. It's unusual to have someone able to think in more than one dimension.

===================
> qt: we often make judgements based on our attitude toward the speaker.

Hence the prevalence of ad hominem attacks by some groups.

 

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