Article / April 20, 2021

Why Inflation Might Be Worse Than You Think

From seasoned economists to market novices, virtually everyone can agree on one age-old truth — prices tend to rise over time. 

That truth, unfortunate as is may be, is called inflation.

By now, you’ve heard us talk about inflation so much that it’s probably becoming annoying. Still, it’s one of the most important economic indicators that exists.

At the risk of sounding like a broken record, we’ve got another data point you probably don’t want to hear: 

Thanks to how it’s typically measured and presented to the public, inflation is probably worse than most people think. 

It’s time we talk about the Consumer Price Index

 

In case you need a quick refresher, inflation in its basic form looks something like this: suppose you paid $10 for a pastry last year and find yourself paying $12 today for that same pastry. In that case, it’s safe to say that the pastry market has experienced an inflation rate of 20%.

The historic rate of inflation in the US

While the calculation for inflation is straightforward, the global economy includes many more variables than just pastries. Steel, lumber, milk, and cars all experience inflation at different rates based on supply and demand for these items. 

Governments make a concerted effort to quantify inflation in the broader economy. The most popular metric is the Consumer Price Index (CPI). 

The CPI’s design makes it applicable as a general measure of inflation across the US economy’s diverse regions. It’s supposed to account for differences in regional consumption and provide a holistic picture of the economy’s overall health.

But there’s a problem. The CPI has grown wildly inaccurate over time. 

According to ShadowStats, which provides alternative inflation data based on early 1980s methodologies, inflation rates have been significantly higher than the official numbers from the Bureau of Labor Statistics (BLS).

Originally the CPI was a cost of goods index, tracking a dynamically weighted basket of preselected commodities. That approach made the CPI a robust metric for calculating inflation. Along with politicians and economists, the Fed continues to use the metric today to adjust policy decisions and moderate public sentiment. 

However, in the mid-1980s, politicians were exploring ways to limit government expenditures. To accomplish that goal, they introduced a series of adjustments to the CPI.  

The narrative espoused was that the CPI overstated inflation and required more substitutions (such as relatively inexpensive hamburger meat for expensive steak). 

The adjustment would reduce the cost-of-living adjustments for Social Security recipients, thus reducing the country’s deficit without politicians having to challenge Social Security publicly. 

Such a transition made intuitive sense for decision-makers. It’s reasonable to track the ebbs and flows that impact the cost of living rather than track a fixed bundle of items, right? Well, there was more to it than that.

The transition also came with the added benefit of pushing taxpayers into a higher bracket, further buffering the country’s coffers. 

With all these incentives for certain participants, the CPI adjustments opened a pandora’s box of substitutions that over time undermined the CPI’s reliability at the expense of the average consumer.

An unfortunate truth

 

The CPI’s slow decline of accuracy is a function of political expediency and shoddy statistics. 

Consider how the CPI currently weights its basket:

Imagine fewer people were eating steak, and more people began eating hamburger meat. Because today steak and hamburger meat are a part of the same bundle in the CPI, the index would weigh hamburger meat more heavily.

By substituting lower-priced and lower-quality goods, the reported inflation rate is lower than the fixed-basket measure used before the 1980s.

As you can imagine, these substitutions do little to identify true inflation yet aid the political argument of subdued inflation and accommodative monetary policy. 

While consumers downgrade the quality of goods they regularly consume due to rising costs, the CPI views those substitutions as shifts in preference and adjusts accordingly. Rather than accurately reflecting the cost of a set basket of goods, the cost-of-living CPI fails to live up to its name.

The current CPI implicitly assumes that consumers will not adjust their standard of living downward to account for economic inflation. Still, everyone knows this does not reflect the economic reality of the vast majority of people. 

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An escalating case for questioning official CPI data

 

In the wake of the Covid-19 pandemic, the CPI’s credibility has further eroded. The metric is no longer trusted as the pinnacle of consumer inflation data as mainstream media sources have increasingly questioned the metric’s validity. 

The latest nail in the coffin for the CPI as a reliable measure of inflation is the imputed prices.

The CPI’s imputed prices skirt around conducting thorough interviews within the economy, allowing the Bureau of Labor and Statistics (BLS) to make the best guess at average prices.

Price imputations are nothing new for government data. However, the scale at which the CPI has introduced imputations is startling. 

Thanks to the Pandemic, over half of the latest CPI data cites imputations as its data source. For example, there’s a 75% increase in responses indicating uncollected rent payments. The latest CPI data suggests landlords will receive unpaid rent at some indeterminate future point. For everyone’s sake, we hope that turns out to be true. 

The chart below depicts inflation compared to recessions over time. Inflation is a lagging indicator of economic performance. Therefore peak inflation is likely to be reported well after economic boom times are over. 

Imagine what the Pandemic distortions will do to inflation numbers once this round of economic expansion reaches its peak.

The CPI has shifted from inaccurate to dubious. With the entire metric being largely guesswork at this point, it would be unsurprising to see reported real inflation numbers flying upward like a rubber band in the coming years.

The best solution to the broken CPI is to focus on the metric’s original purpose. 

As a reliable method of tracking consumer inflation, the CPI should calculate inflation with a fixed basket of commodities with an extremely limited amount of substitutions. 

By transitioning back to a cost-of-goods index, we can begin to talk again about reliable, universally acceptable consumer inflation metrics. 

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