Measuring Inflation…It’s Complicated
July 2015
By Neil G. Bleicken
Inflation is a topic discussed by almost everyone. We see inflation every day in the prices of the food we
eat and the products we use. It’s also a topic of great importance to policy makers in Washington for two
primary reasons. First, important government programs are adjusted by the use of an inflation measure
with the best known being the Cost-Of-Living Adjustment (COLA) to Social Security Benefits and the
calculation used to value Treasury Inflation-Protected Securities (TIPS). For data that is compounded
over long periods of time, the accuracy of any part of that calculation is very important because small
changes can have large effects.
Second, and perhaps more importantly, the Federal Reserve is most comfortable when managing an
economy in which prices are rising. They don’t do this perfectly and there are plenty of examples of
miscalculation and error but the basic proposition of using interest rates (and now other tools) to keep the
economy operating at a healthy, long-term pace works pretty well. As our economy grows, the prices of
goods and services will rise as banks make more loans, new factories and houses are built, jobs are
created, wages rise, and demand for most things increases. To avoid high rates of inflation that can do
great harm to the economy (and society generally), the Fed will ultimately raise rates in an attempt to
slow economic growth and then eventually lower rates once they judge that the economy has slowed
enough so that restarting it will not do harm.
In contrast, trying to manage an economy with prices that are declining is much more difficult and
fraught with real systemic risk with the best example of such a period being the Great Depression. The
permanent influence of that searing experience upon the policies of the Federal Government and the
private sector cannot be underestimated and most agree that its repetition should be avoided if at all
possible. Indeed, the only way to manage the economic cycle to affect that end is for decision-makers to
have the best and most accurate data available to them, especially with regard to measuring inflation. As
a result, the Federal Government expends significant resources collecting and analyzing one of the most
thorough and accurate economic databases in the world partially for that purpose.
Inflation is also an important topic for professionals who help their clients invest and plan for the future.
In particular, financial planners and wealth managers use inflation to analyze and adjust data to
determine their “real” value or to measure their relative performance over time. We at Harvest Capital
are interested in inflation because of both the impact it has on the investment decisions we make and our
need to measure the relative value we provide to our clients through performance reporting. As a result,
we had to decide which inflation index was the best to use for these purposes and we spent several
months conducting our own research on the topic and working with outside specialists to make that
determination. The external professionals we consulted included subject matter experts at the Bureau of
Economic Analysis (BEA) at the Department of Commerce, the Bureau of Labor Statistics (BLS) at the
Department of Labor, a leading and well regarded commercial research service, and one of the world’s
largest investment management firms. Through this process we discovered that while the amount of
accurate data about inflation is extensive and has been recorded for over 100 years, the decision about
which index to use is complicated and subject to a user’s judgement and intent. With this in mind, we
thought it might be helpful to describe the measures of inflation available and the reasons for the decision
we made.
1 Perhaps the most important concept to highlight initially is that while inflation is reported as a single
number, it has many component parts that change constantly. Said another way, while an inflation index
is designed to measure the general level of price changes in an economy, that general level is made up of
the movements of a great number of different goods and services. While home prices are going up, cell
phone prices are declining, and gasoline prices are doing both. And with the change in the price of each
good or service individuals are also altering their behavior by typically buying more items with declining
prices and fewer items with increasing prices. So, to try to accurately measure the change in the general
level of prices, a representative sample (or “basket”) of goods and services is created which attempts to
track the experience of a household or consumer at a specific standard of living through time to
determine what it would cost to buy that same basket in different periods.
There are two primary inflation indices: the Consumer Price Index (CPI) produced by the BLS and the
Personal Consumption Expenditures Price Index (PCEPI) produced by the BEA. Most of the data is
collected by the BLS and it provides the foundation for the creation of both the CPI and the PCEPI.
We have reviewed the different methodologies employed to compute both and list the key differences
between the two in the table below:
Table 1: Key Differences Between the CPI & the PCEPI
CPI
PCEPI
“Basket” Scope
Consumer Focus
Consumer Oriented
Out of Pocket Expenses
Weighting
Updates
Key Differences
Various (see below)
General Economy
Expenses by Households and
Nonprofits & Employers
Every Quarter
Lower Weight for Health
Care Expenses than PCE
Social Security COLA /
TIPS Calculation
Bureau of Labor Statistics
/ Department of Labor
Lower Weight for
Rent/Housing Costs than CPI
Federal Reserve Policy Decisions
/ Macroeconomic Analysis
Bureau of Economic Analysis /
Department of Commerce
Key Index Use
Author
Sources: Various – See References Below
Even though we often hear the term “inflation” discussed as if its definition and use were universally
accepted, we have learned that this is far from true. Indeed, while we don’t believe there’s anything
flawed with the data that’s collected by BLS or the calculations made by either bureau, we do believe
users of inflation indices must be thoughtful and deliberate about which one they decide to use.
For our purposes, we seek to use a measure of inflation that relates to our clients’ lives and as a Family
Office (FO) most of our clients are families and individuals as opposed to institutions. For example,
while we agree with the idea that the financial assets with which we populate our clients’ portfolios
reflect companies or investments that are part of, and respond to, activity in the general economy, our
intention is to provide our clients with a measure by which they can judge the performance of these
assets with respect to their intended purpose: to purchase consumer goods and services whether it be for
the current generation or future generations. As a result, we decided to use the CPI which has a greater
orientation toward the lives of the individuals and families we serve.
That said, there are three different CPI indices that are produced by BLS and each has very different
characteristics and potential uses which are summarized in the table below:
2 Table 2: CPI Indices Produced by the Bureau of Labor Statistics
Start Year
Sample Focus
% US Population
Key Index Use
Weighting Updates
Substitution
Calculation Method
When Finalized
CPI – W
CPI-U
C-CPI-U
1913
Urban Wage
Earners
and Clerical
Workers
32%
Social Security
COLA
1978
All Urban Consumers
2002
All Urban Consumers
87%
None
Every 2 Years
Geometric Mean
87%
TIPs Valuation,
Federal Income Tax
Brackets
Every 2 Years
Geometric Mean
First Reported
First Reported
Every Quarter
Constant Elasticity of
Substitution Formula
10-12 Months
After First Report
Sources: Various – See References Below
Of the three, the CPI index most frequently referenced and used is the CPI – U (the Consumer Price Index
– All Urban Consumers) although the first CPI index created was the CPI – W (the Consumer Price Index
- Urban Wage Earners and Clerical Workers) which was started in 1913. The benefits of using the CPI-U
instead of its older version are clear as it covers 87% of modern America’s population compared to only
32% for the CPI-W. That said, both share two significant flaws that are referred to as “substitution bias”
and “small sample bias.” Substitution bias refers to the manner by which these two indices measure the
way consumers substitute other goods or services for items that are increasing (or decreasing) in price.
Small sample bias refers to the effect of using a smaller sample of items when calculating an index. The
effect of both the substitution and small sample biases is to slightly overstate the rate of inflation. To
compensate for these effects BLS created the C-CPI-U (the Chained Consumer Price Index – All Urban
Consumers) which uses different methodologies to compensate for these two issues.
While it is clear that the Chained CPI-U is the more precise measure of inflation because it corrects the
biases of the other versions, there are two very important points that make its use in our performance
reporting or, for that matter, in government programs less appealing. First, the Chained CPI-U is a data
series that is revised over time. When the Chained CPI-U is published it is only an initial estimate and its
final version is determined 10-12 months later which makes its use for any real time purpose problematic.
For example, if Harvest were to report quarterly performance for the past year and use the Chained CPIU as a comparative benchmark then it’s very likely we would report a different number the next quarter
when covering essentially the same period of time.
Second, the actual computational differences between the Chained CPI-U and the traditional CPI-U,
while material, are not significant for our purposes. For example, the table below shows the difference
between the two when reporting their annualized rates:
3 Table 3: Annualized Inflation as of May 11, 2015: CPI-U vs. C-CPI-U (not seasonally adjusted)
Trailing Periods
CPI-U
C-CPI-U
CPI-U minus
C-CPI-U
YTD
4.19%
4.85%
-0.66%
1-Year
-0.40%
-0.73%
0.33%
3-Year
0.87%
0.65%
0.22%
5-Year
1.61%
1.43%
0.18%
10-Year
1.95%
1.75%
0.20%
15-Year
2.16%
1.91%
0.26%
Sources: Bureau of Labor Statistics web site; Harvest Capital Management
Table 3 shows how close the two indices are to each other and how consistently the traditional CPI-U
reports a higher reading than the Chained CPI-U. In addition, the annualized year-to-date result in the
table demonstrates how inaccurate the short term measurement of inflation can be because we know for
certain that the current economy’s inflation rate isn’t over 4%.
What was also helpful to learn is that the Congressional Budget Office (CBO) has reviewed the
differences between the traditional CPI-U and the Chained CPI-U at great length and concluded the
following:
“The chained CPI-U results in lower estimates of inflation than the traditional CPI
does. CBO expects that annual inflation as measured by the chained CPI-U will be
about 0.25 percentage points lower, on average, than annual inflation as measured by
the traditional CPI. That estimate is based in part on the observed past differences
between the chained CPI-U and the traditional CPI-U and CPI-W.”1
Also relevant to our decision was the discovery that the CPI-U’s seasonally adjusted version can be
revised for up to five years after any data is reported and that the Chained CPI-U does not yet have a
seasonally adjusted variant.
Next, to complete our analysis we needed to determine the importance of food and energy prices to our
decision. Typically, economists and policy makers will exclude food and energy prices from inflation to
get the best understanding of what inflation is doing. They believe that the volatility of these prices
distorts the truth of price movements in the general economy and so will use an inflation index that
excludes them – referred to as a “core” index – to determine policy. If, in fact, we were policy makers we
would make this same decision and separate this “noise” out of the data to get the best “signal” but since
our intention is to use the measure of inflation that best replicates our clients’ lives, we have a bias toward
including food and energy prices because, quite literally, the people we serve care a great deal about real
time food and energy prices.
Therefore, we reviewed the differences between the traditional CPI and its core version and the results
are in the table below:
1
Robert McClelland, “Differences Between the Traditional CPI and the Chained CPI,” CBO Blog, May 11, 2015, https://www.cbo.gov/publications/44088. 4 Table 4: Annualized Inflation as of May 11, 2015: CPI-U vs. CPI-U Core (not seasonally adjusted)
Trailing Periods
CPI-U
CPI-U Core
CPI-U minus
CPI-U Core
YTD
4.19%
3.08%
1.12%
1-Year
-0.40%
1.50%
-1.90%
3-Year
0.87%
1.68%
-0.82%
5-Year
1.61%
1.74%
-0.13%
10-Year
1.95%
1.84%
0.11%
15-Year
2.16%
1.93%
0.23%
Sources: Bureau of Labor Statistics web site; Harvest Capital Management
As the table makes clear, while there are significant differences between CPI-U and its core version, those
differences are most pronounced during the shorter periods being measured and dissipate quickly as the
time horizon expands.
As a result of this research and analysis, we decided to use the traditional CPI-U in our reporting to
clients. We didn’t choose the seasonally adjusted CPI-U or its Chained version because both are subject
to revisions for significant periods of time and we didn’t choose the core CPI-U both because our clients
care a lot about food and energy prices and, over longer periods of time, the difference between
traditional and core CPI is not significant for our purposes. The traditional CPI provides us with a timely
report that doesn’t need to be revised and because we know that it overstates its results by about 25 basis
points we also have an accurate reading of inflation as well. We continue to monitor the methods by
which the BLS and the BEA measure and report inflation and if modifications are made that will enable
us to provide even more accurate and timely results then we will make the change and inform our clients.
But, for now, we believe this provides a good and useful solution to a challenge that was much more
complicated and difficult than we first realized.
Neil G. Bleicken is a Portfolio Manager at Harvest Capital Management in Concord, New Hampshire.
5 References
“What is inflation and how does the Federal Reserve evaluate changes in the rate of inflation?” Board of
Governors of the Federal Reserve System, n.d. Web. April 10, 2015
“About the Median CPI.” Federal Reserve Bank of Cleveland., n.d. Web. April 10, 2015
Yifan Cao and Adam Hale Shapiro. “Why Do Measures of Inflation Disagree?” Federal Reserve Bank of
San Francisco Economic Letter 37 (December 9, 2013). Web. May 8, 2015.
Kenneth V. Dalton and Kenneth J. Stewart. “Incorporating a geometric mean formula into the CPI.”
Bureau of Labor Statistics, Monthly Labor Review (October 1998). Web. May 11, 2015.
Douglas W. Elmendorf. “Using a Different Measure of Inflation for Indexing Federal Programs and the
Tax Code.” CBO, Economic and Budget Issue Brief (February 24, 2010). Web. May 12, 2015.
J. Steven Landefeld, Brent R. Moulton, and Cindy M. Vojtech. “Chained-Dollar Indexes.” Bureau of
Economic Analysis, Survey of Current Business (November 2003). Web. May 8, 2015.
Steven Landefeld and Robert P. Parker. “BEA’s Chain Indexes, Time Series, and Measures of Long-Term
Economic Growth.” Bureau of Economic Analysis, Survey of Current Business (May 1997). Web. May 8,
2015.
Robert McClelland. (April 19, 2013). Differences Between the Traditional CPI and the Chained CPI.
[Blog Post]. Retrieved from https://www.cbo.gov/publications/44088. May 11, 2015.
Clinton P. McCully, Brian C. Moyer, and Kenneth J. Stewart. “Comparing the Consumer Price Index and
the Personal Consumption Expenditures Price Index.” Bureau of Economic Analysis, Survey of Current
Business (November 2007). Web. May 8, 2015.
Stephen B. Reed and Kenneth J. Steward. “Why does BLS provide both the CPI-W and CPI-U?” Bureau of
Labor Statistics, Beyond the Numbers 3/5 (February 2014). Web. May 8, 2015.
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