Does the CPI Accurately Measure the Inflation Rate?
By Elaine Floyd, CFP®
Every month the Bureau of Labor Statistics (BLS) tracks the prices of more than
80,000 goods and services and distills them into one number, the Consumer
Price Index (CPI). In September 2007 the CPI was 208.490 (1982-84 = 100),
which was 2.8% higher than in September 2006. Upon release, newspapers
around the country reported that inflation was running 2.8%. A lot of people didn't
believe it.
Market participants were skeptical because they had seen huge price increases
in several commodity prices during 2007: oil up 50%, gold up 23%, and the DJAIG Commodity Index up 8.5%. Consumers wondered whose market basket of
goods and services the CPI was measuring because it certainly wasn't theirs:
everything, it seemed, was costing more these days, from airline tickets to a
dozen eggs.
Meanwhile, the Federal Reserve Board, which keeps its eye on the "core"
inflation rate, observed that, when energy and food were removed from the
index, the inflation rate was just 2.1%, which was perfectly acceptable. In fact,
the Fed concluded at its October 31st meeting that the risk of recession was
sufficiently higher than the risk of inflation that a second reduction in the target
short-term interest rate was in order. The Fed noted in its statement, however,
that recent increases in energy and commodity prices could put renewed upward
pressure on inflation.
Everyone, it seems, has a different take on inflation. It is not new for consumers
and market participants to question the CPI. Because it is used in many
governmental formulas to adjust tax brackets, retirement plan contribution limits,
and Social Security benefits among others, people have accused the government
of manipulating the numbers for their benefit. On the other hand, the Bureau of
Labor Statistics cites painstaking, comprehensive, and objective procedures that
it uses to compile pricing information: the prices are what they are.
Still, the way the prices of the 80,000 goods and services are factored into the
CPI leaves room for question. Following are some of the reasons the CPI might
not represent people's perception of inflation:
Composition of the market basket. The prices of the various goods and
services that make up the CPI are weighted according to a standard market
basket that represents the way people spend based on the Consumer
Expenditure Survey. The category weightings are as follows:
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Food and beverages
Housing
Apparel
Transportation
Medical care
Recreation
Education and communication
Other goods and services
15%
43%
4%
17%
6%
6%
6%
3%
If spending patterns diverge from these weightings, individuals may perceive
inflation to be higher or lower than the 2.8% reported in the CPI. For example,
the cost of medical care rose at a rate of 4.6% in the 12 months ending in
September 2007. If a family spent more than the standard allocation of 6% on
medical care, their own personal inflation rate would be more than the stated
2.8%.
One component of the market basket – housing – warrants additional scrutiny.
The “shelter” component of housing represents 32% of the total CPI index. CPI
calculations use implied rent figures when computing housing costs, rather than
the cost of home ownership. Until recently, home prices rose dramatically while
rent costs lagged, leading some economists to believe that the CPI was
understating the true rate of inflation. With the recent decline in housing prices
and home equity, homeowners who can no longer afford their homes may be
forced to rent, forcing rental rates higher, and possibly having a dramatic effect
on the CPI.
In many respects, the cost of energy –specifically oil- attracts the most attention
for consumers. With oil prices nearing an all-time inflation-adjusted high, many
consumers are fearful of the effect this will have on their budgets. But
automobile gasoline represents just 4.4% of the CPI, while public transportation
represents 1.1%, and household fuel oil is a mere .2%. So the direct effect of
increases in oil prices will not substantially impact the CPI. The greater concern
is whether oil price hikes will persist and permeate other aspects of the economy.
There is no reason to believe that oil prices are artificially understating the
reported CPI rates; the concern is the effect they will have on future rates. One
point to bear in mind is that the price of gasoline in the futures market is currently
below the spot market (a characteristic which futures traders call
“backwardation”), implying that the market believes that the current oil price hikes
may be temporary. Lastly, energy costs are closely connected to wages, and the
growth in wages (after adjusting for inflation) has managed to keep pace with
energy costs.
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Jeffrey Roach, Chief Economist with Horizon Investments in Charlotte, NC. cites
a trend among economists to follow the market-based PCE deflator as a
measure of inflation. Unlike the CPI, the PCE tracks all consumer expenditures,
rather than a fixed basket of goods. According to Roach, current PCE data
suggests that “inflation is not as bad an issue as some are talking about” and that
the CPI may actually slightly overstate the actual rate.
Behavior of shoppers. The composition of the CPI market basket is adjusted
infrequently, sometimes at intervals as long as ten years. In 1998 several
changes were made to the way the CPI is calculated. One of these changes
relates to the way people shop. Instead of buying the same item every week,
they might be alert to temporary price hikes and substitute a cheaper item when
possible. If their favorite brand of ice cream is more expensive than usual, for
example, they might switch brands, buy it at a different store, buy a smaller size,
or settle for a different dessert. This substitution adjustment has the effect of
lowering the CPI, compared to using prices for the same items every week. . In
addition to substitution bias, the CPI does not react quickly to the introduction of
new products, particularly in the technology sector, says Roach. Roach cites a
third criticism that has been leveled against the CPI is that, although it adjusts for
improvements in the quality of goods and services, the time lag in incorporating
these effects may bias the numbers.
Lag time. The Federal Reserve Board focuses on core inflation to avoid
implementing monetary policies that take time to filter throughout the economy. If
it were to raise interest rates every time energy prices spiked, for example, it
would lead to undesirable changes in employment and other economic
conditions. The Fed calls the price movements in food and energy "noise."
Although they jump around from month to month, it is the longer term trend that
must be observed, so that the central bank will not respond too strongly to
transitory movements in inflation. Board member Frederic S. Mishkin has written
extensively on headline versus core inflation in the conduct of monetary policy.
On the other hand, the big price jumps in energy and food that have taken place
this year suggest to many that they are not just noise, but are destined to have a
serious impact on the inflation rate and the economy. In the first and second
quarters of 2007, the energy index advanced at annual rates of 22.9% and
32.9% respectively. After declining at a rate of 14.8% in the third quarter, the
energy index was up 11.7% for the first nine months of 2007, compared to a
2.9% increase in all of 2006. The food index rose at a 5.7% annual rate in the
first nine months of 2007 after advancing 2.1% in all of 2006. It is hard for some
people to look at these numbers and feel as complacent about inflation as the
Fed seems to be -- especially when they hit directly in the pocketbook.
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How individuals perceive the inflation rate may ultimately depend on what they
do with the information. Individuals living on a budget or factoring an inflation rate
into their retirement plans need to have a realistic perception of inflation as it
relates to their own spending patterns. Retirees facing large health care
expenditures, for example, may want to assume an inflation rate that is
significantly higher than the CPI. Market participants who are primarily interested
in understanding how inflation will impact future security and commodity prices
may react more to the "noise" that the Fed is trying to ignore in an effort to profit
from price discrepancies.
For its part, the Fed is walking a fine line between being responsive to inflation
without overreacting. Part of its agenda, as Board Chairman Ben Bernanke noted
in a July 2007 speech, is keeping people's inflation expectations low. If inflation
expectations are not well "anchored," they can lead to wage-price spirals that
threaten to make high inflation a self-fulfilling prophesy, and that's the last thing
the Fed -- and the American consumer -- wants.
Elaine Floyd, CFP®, is a freelance financial writer based in Bellingham,
Washington.
For More Information:
Frequently Asked Questions about the CPI
The Effects of Rounding on the Consumer Price Index
Inflation Disconnect?
Topic Report: How the Government Measures Inflation
The Upside of Recession
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