Core inflation as a Potemkin Village of the real (headline) inflation

Ron Paul recently suggested that there is no a single person in the US who believes the CPI numbers. And it really looks like core inflation systematically underestimates the real inflation by a wide margin (1% or more that means 30% or more).  That does not mean that core inflation is meaningless: price changes in food and energy have historically exhibited less serial correlation than most other categories,  so the current trend in inflation might be visible slightly more clearly in core inflation. 

At the same time it is difficult to proved that such a simplistic approach as CPI (throwing baby with a dirty bathwater)  is better then other variants in which food and energy in included in form as some kind of average for the recent period. Core inflation is an OK concept only if you understands the limit of applicability. What is meaningless (and there is a consensus here) is the absolute value of CPI.  Taken as an absolute value  core inflation is not only underestimates actual ("headline") inflation, the measure itself is rotten to the core :-).

There is probably no other area in which level of deception by Greenspan reached such heights as in the question of inflation (core inflation concept was introduced by author Burns with the explicit aim to serve as a smokescreen that masks the rampant real inflation).  Greenspan resurrected CPI and advocated it with such zeal that it is clear that "great chairman" have some far from altruistic motives. But that's another story... 

One explanation of the idea of core inflation is an implicit assumption that food and energy prices are "in a long run" reverting to the mean. But the recent trends in food and energy are definitely not mean reverting. Moreover at some observers suggest that if counted in an "old fashion" without all those "hedonistic adjustments" the real (headline) inflation for the last decade was around or even over  5% per year. So much for "death of inflation" hypothesis. 

Recently there were even voices that real inflation is around 8%.  For example one recent (March 14, 2008) post  "Is US Inflation at 8%?"  in Naked Capitalism blog states the following:

Wolfgang Munchau, who writes for the Financial Times as well as the blog Eurointelligence, ruminates about inflation statistics and argues that economists and statisticians may be going down the wrong path in dismissing consumers' subjective perceptions. He also has considerable doubts about hedonic adjustments (basically, the methodology for adjusting for the fact that computers and other devices have become cheaper for the same performance, and that even seemingly mature products, such as cars, have features they lacked a decade ago (think GPS and more self-diagnostics).

While his post is helpful, he misses some of the other adjustments that, at least in the US, lead to the official understatement of inflation. The Boskin Commission in late 1996, which was chartered to adjust the CPI calculation (remember, at this point Social Security payments were indexed to CPI) rather conveniently concluded that CPI overstated inflation by 1.1% in 1996 and roughly 1.3% per year in prior years. And of course, the CPI methodology was then adjusted to produce lower numbers, therefore reducing Social Security payment increases.

What did the Boskin Commission think was out of line? According to Wikipedia:

The report highlighted four sources of possible bias:

Substitution bias occurs because a fixed market basket fails to reflect the fact that consumers substitute relatively less for more expensive goods when relative prices change.

Outlet substitution bias occurs when shifts to lower price outlets are not properly handled.

Quality change bias occurs when improvements in the quality of products, such as greater energy efficiency or less need for repair, are measured inaccurately or not at all.

New product bias occurs when new products are not introduced in the market basket, or included only with a long lag.

So the Boskin report would have us believe that if I switch from steak to hamburger because beef prices are up, we should only capture the change in how I consume (ie, inflation is new hamburger/old steak price, not new steak/old steak). That is patently bogus. Similarly, the outlet substitution seems rife for abuse ("Ooh, the number is going to be really bad this month! Can we find anywhere selling X cheaper so we can put that in the model instead?").

From Munchau:

... ... ...

Well, I have my doubts - and this is not a psychological argument, but a statistical one. The first thing to notice is that inflation is not an observable real world variable, such as the number of widgets produced by a factory. Inflation is a statistic - technically a mapping from a probability space of random events into the positive real numbers. To arrive at a statistic, i.e. a number, we have to take multiple decisions, such as which sample of goods to include in our basket, since we cannot measure the universe of prices. We also have to choose a method how to weigh the results mathematically. You might remember the Paasche or Laspeyres price indices taught in Economics 101. In particular, we have to choose what to put into the basket, and what not.

In the 1950s, this exercise was easy. In the UK, I was told by someone who was actually involved in this exercise that they had chosen a typical working class family, and looked at their consumption basket, which was relatively uniform by today's standards. They would pay rent, consume a certain amount of energy, obviously much of the spending went into foods, household goods, and some durables. The RPI, the retail price index, is still used today by ordinary people as their favourite measure of inflation (and also by wage negotiators). It has been significantly higher than the CPI, the index targeted by the Bank of England.

The reason for this discrepancy is, of course, related to what we put into the basket and to the adjustments we choose to make. We make lots of adjustments. If the price of a family computer at your local hardware costs €1000 today, and €1000 in one year's time, we calculate this as a fall in prices, because the quality of the computer has presumably increased. I have problems with this now ubiquitous concept of hedonistic pricing because we are double-counting. The improvement in quality is the result of a rise productivity - which is a real variable. So the improvement in quality raises nominal growth in the numerator, and it lowers the price in the denominator, in other words, we double-count the effect. It may well be that we have been consistently underestimating the rate of inflation, and overestimating the rate of real productivity growth. Since the US uses the hedonic pricing more consistently than the Europeans (I think, please correct me if I am wrong on this one), the problem would be worse in the US than in Europe.

There is a website called Shadow Government Statistics, for whose accuracy I cannot vouch, which claims that the pre-Clinton era inflation index shows current inflation at close to 8%, while opposed official CPI inflation is only half that level. Here is the chart. What makes me a bit doubtful is that the higher series is an almost perfect image of the lower series (just follow it turn for turn), so that it may be calculated as actual inflation plus x%. That would not be a very acurate way to do this.

But let us suppose for a moment that series is correct. If US inflation were really 8%, this would mean that interest rates in the US have been negative at all times in the last 10 years. It would mean that 10-year treasuries, which yield only a little over 4%, are massively mispriced, that a bond price crash of historic proportion would beckon, essentially wiping out a large amount of China's and Russia's wealth - countries that have heavy investors in the US. It would be a global economic catastrophe. So we are not going to switch back with ease and pleasure. There are many vested interests in not doing so.

I do not want to discuss the merit of this particular statistic - which I cannot - but I believe strongly that the Fed is absolutely wrong to target a core-inflation index (and it is not even doing that with any great conviction and success). Core inflation is supposed to be more stable, as it excludes volatile categories of food and energy, but both categories have not been volatile, but persistently rising. To exaggerate a little (well, ok, a lot): All the troublemakers are taken out of the basket, the rest is adjusted.

But if some of the criticisms of the modern inflation indicators are even remotely correct, it would not only mean that we are about to return to a 1970s period of stagflation, with its double-digits inflation rates in the US and in some European countries. With the Fed now swamping the market with cheap money as though there is no tomorrow, it could be a lot worse than that.

One reader wrote to me that the 8% estimate for US inflation is probably still too optimistic, as it does not fully take into account the rise in wheat and other commodity prices, for example. Another important side effect of a potentially misjudged inflation series is that US growth is actually not higher than European growth - a claim that has lead to much soul-searching over here - as we are deflating nominal GDP growth by an excessively modest indicator. As for the apparently superior performance of the British economy, just try to deflate all those nominal prices by RPI, not the actual GDP-deflator used, and the economic miracle disappears.

... ... ...

While an artificially depressed inflation indicator may make life a lot easier for a central bank, we know we cannot fool all of the people of the time. This was just tried in the credit market. Another catastrophic Ponzi game would eventually come unstuck. The last think we want after this credit crisis is over, is for central banks to put up nominal short term rates to 20% to contain runaway inflation. Contrary to popular wisdom in the US, it may be better not to cut them now, as opposed to cutting now, and hiking later.

Here are some interesting observations based on initial set of Larry Edelson:

• In 1996 two bedroom apartment rent in NJ was between $800 and $1200. Now it is between $1200 and 2500. For renters this is one of the biggest expense items in family budget and here we definitely see 5% per year inflation.
• From 1996 to 2006 a gallon of gasoline at full-service stations jumped from $1 to $3 (300% per 10 years or approximately 30% a year).  As food prices are heavily correlated with gasoline prices they also jumped considerably: for example apples from approximately $1 to approximately $2 (100% per decade, or 10% per year).  A loaf of Italian bread from $1.20 to $3.50
• "A postage stamp in the 1950s cost 3 cents; [today] it's 41 cents: That's 1,266% inflation.
•  "In 1959, the average price of a new house was $14,900; [today] it's $220,900: That's 1,382% inflation, despite the recent price dip in the real estate market.
• "A dental crown used to cost $40 in the late 1970s; today it is around $1K. That's 3,000% inflation.
• "In 1970, seniors paid $5.30 a month for Medicare insurance. Today, they pay $93.50 a month. That's 1,644% inflation."

There are also some problems with using the substitution in calculation of CPI.  This is not the cost of living but the cost of survival by quoting Peter Schiff July 31 2007 CNBC

"It does not matter what the Fed think. What's matter is reality. I don't care what the Fed think. I know what they saying. But they have an agenda"

It might be that the Feds are living in their own "core world" and wonders why the inflation expectation are imperfectly anchored..... As Barry Ritholtz aptly noted in  The Big Picture QOTD Bernanke on Inflation:

Peter E. Kretzmer, senior economist for Bank of America, explains (more or less) what the Fed means  by relating "inflation expectations" to the ability of the Fed to impact price rises (i.e., stability):

“This Fed much more so than prior Feds puts a very heavy emphasis on the role of inflationary expectations,” he said. “They believe, and research shows, that inflation expectations and the Fed’s inflation-fighting credibility has a large impact on private sector wage- and price-setting behavior.”

In other words, the Fed's emphasis on Core inflation -- jawboning, PR, propaganda, whatever -- is every bit as important to future prices as the actual underlying causes (excessive monetary creation, demand exceeding commodity supplies) of inflation.

I am not sure I buy that. Surely, psychology is important, and the collective expectations of either higher or lower prices can impact subsequent price behavior. 

But this approach puts the Fed into the role of a low price cheerleader, and runs the dangerous risk fo well, artificially emphasizing the irrelevant core rate of inflation rather than dealing with reality of the actual price increases as experienced by consumers.

Also the exclusion of food and energy that is practiced in calculating so called "core" inflation is a very strange idea. You can smooth the spikes in prices of food or energy by various methods but to exclude then is to equal to throwing the child with the bathwater.  Or need Maestro Greenspan "confidence building" trick.

See also Bloomberg. COM Opinion

Three years later, with crude oil prices hitting a record $78.40 in July, the CPI was rising 4.1 percent. In all that time, the price of something else should have fallen to offset the higher oil prices. The fact that it didn't means our friendly central bank was accommodating the oil-price increase, printing enough money to prevent that from happening.

For the record, the core inflation rate has almost doubled to 2.7 percent in July from 1.5 percent three years earlier.

Recently some soft but solid voices have started to challenge the Fed's choice of a core index, in part because oil prices have been ``volatile'' in one direction -- up -- for most of the last three years.

Stephen Cecchetti, professor of economics and finance at Brandeis University's International Business School in Waltham, Massachusetts, and a former research director at the New York Fed, thinks the core is an unreliable guide.

"Since the goal of policy makers is stable prices overall, including those of food and energy, they should turn their attention to forecasts of headline inflation and stop focusing on core measures,'' Cecchetti wrote in a Sept. 12 op-ed in the Financial Times.

Core inflation has been running consistently below overall inflation for the past decade by about one-half percentage point, he said. The source of the discrepancy is ``in the relative price of energy that has been persistent,'' he said in an e-mail exchange earlier this week. ``Surely, the central bank's objective should not be a biased measure of medium-term inflation.''

Based on government CPI based inflation calculator $1000 in 1995 was equal in purchasing power to $1336 in 2006. That means that you can assume approximately 30% deterioration of purchasing ability of dollar for each 10 years "in good decades" and double of than in "bad and regular decades".  In the US today, government employs 7.7 million more people than does manufacturing. Little wonder we have an $800 billion annual trade deficit when the government sector is larger than the manufacturing sector.

Also with fiat currency the tendency to abuse money printing press is the historical norm. If you assume that average annual return on 401K account is within the range of  2-6% (2.7% based on Vanguard data) then inflation alone almost guarantee zero real return for most 401K owners: you can get back only the amount of money you put into it.   That means that your pension via 401K is essentially should be self-funded.

Government does not publish the statistics as for average 401K accounts return (they are formally private accounts despite the fact they were created by government decree and are heavily regulated) as this will reveal far from pretty picture.  I suspect that very few, probably less then 30% of owners of 401K account, will get ahead by getting higher then 5% annualized returns. See also Inflation conversion factors for dollars 1665 to estimated 2016 to ...  and trends.  Factoring in inflation on average 401K accounts makes average returns (2.7% by some estimates) are negative and in this sense represent 401K tax. 

Actually factoring in inflation helps to see the real picture in many other areas: For example the median hourly wage for American workers has declined 2% since 2003.  [Real Wages Fail to Match a Rise in Productivity - New York Times]. If you take into account growing cost of health insurance this is closer to 5%  for some categories of professionals, the  decline of real wages was  for the same period 10% or more. 

Some people even claim that inflation numbers are maliciously manipulated. for example Charles Hugh Smit in his blog entry Is the USA a Giant Enron  made the folllowing arguments:

I. Bogus inflation numbers. I have covered this at length over the past few years; please refer to the links in this entry for more: Inflation/Deflation II: Is The Answer How We Measure? (January 9, 2007)

The best single source for information on the "real" rate of inflation (roughly 6-7%, not the phony 2% cited by our government agencies and the Fed) is John Williams' Shadow Government Statistics Analysis Behind and Beyond Government Economic Reporting.

The site has in-depth analysis of just how the CPI etc. is manipulated: GOVERNMENT ECONOMIC REPORTS: THINGS YOU'VE SUSPECTED BUT WERE AFRAID TO ASK!

A deceptively low rate of inflation is the essential Big Lie behind our economy and financial system. As Fed Chairman Bernanke often reminds us, inflation lies (pun intended) in the mind: once inflationary expectations are built into citizens' minds, inflation becomes a reality. So the key job of the government's "factoid" factories is to create the illusion of low inflation.

How can anyone be foolish enough to doubt their own experience? Hasn't anyone else noticed that gasoline prices that used to start with 2 now start with 3? Has no one else seen the costs of milk, meat, grain, education, medical care, drugs, government fees (hidden taxes) skyrocket, even as the Fed crows about the fake PCE and "core" inflation rates remaining at 1.9%?

Unfortunately, we all have the ability to ignore experience in favor of "official reality." This was starkly and sadly illustrated last year when a techie and his family became lost in the backroads of Oregon. Despite the fact that the road was unlit and unpaved and progressively becoming more primitive, the man continued to place his faith in a map he'd printed off the Web. Thus do we deny the reality in front of our noses because the "official and therefore trusted" Fed claims inflation is minimal.

Of course the deceptive practice of breaking out "core inflation" began in the high-inflation early 70s as a method of masking the inflation everyone was seeing with their own eyes. The deception worked so well that it remains a key tool in the "Emperor has no clothes" toolbox.

Want to keep that pesky entitlement spending down? Make sure the inflation/ cost-of-living adjustment to those millions of checks remains artificially low.

With the introduction of hedonics and substitution into inflation calculations in the 90s, inflation rates began to come out lower than using previous forms of measurement. so lower inflation during recent period can be partially explained by changes in the methodology of its measument.  Also CPI does not measure home prices, the area of economic where inflation has been rampant.  It measures much less inflationary thing called owner's equivalent rent. And even as house prices rose by 93% in real terms (per Professor Shiller) in the last decade, rent in real terms go up less then 50%, so the large part of growth in the cost of a new home was not reflected in the CPI.

Measured the same way as in the 1980s, inflation has been way above the Fed Funds rate for a long, long time. That was one of  the neat confidence tricks that Greenspan Fed played (another one was moving surpluses of social security collection into surpluses of budget -- fake surpluses of Clinton era).  They also sent clear signal to consumers that it's much better to borrow than save.  And that in turn further stimulated inflation but at the same time moved it from inflation of goods into inflation of assets (stocks, houses and, now, commodities). 

Investors now know all too well that official core inflation figures are a gross underestimation of real inflation. 

That not only because headline inflation is underestimated by government statistics, but also because CPI was specifically designed to reduce the weight given in the indexes to goods and services whose prices increase the fastest, as well as to underestimate housing costs.

This might partially  explain why inflation expectations are on the rise, and credibility of Fed is decline (number of jokes and nicknames for Greenspan attest this pretty clearly). That's probably why gold is having such a wild ride and might even turn into a bubble of its own. If people do not believe official figures and try to protect their investment from betting wiped out gold is the natural defensive play. Unrestrained credit expansion first fueled assets bubbles, but now this "asset inflation" moved to the prices of all commodities as well as the prices of food and medical services.

With the current drop of the dollar, 401K investors can be expected to pay a lot more for such items as medical services, fuel and food. This  translates to a lower standard of living for the same amount in 401K account even without cuts in Social Security. 

Now even mainstream press in skeptical about the rosy official picture of word with benign inflation with "core" below 2% [Bloomberg.com]:

The U.S. consumer price index continues to be a testament to the art of economic spin.

Since wages, Social Security cost-of-living increases and some agency budgets are tied to it, the government has a vested interest in keeping it as low as possible.

Yet your real cost of living -- what you keep after taxes, medical bills, college expenses and other household costs -- is probably much higher than the 2 percent annual rate the government reported in July, showing a slight decline.

Millions are falling behind inflation because wage increases aren't keeping pace with the cost of medical care, lost employment benefits, homeownership expenses, energy and transportation.

And there's also a goliath looming in the U.S. economy that makes the government's consumer gauge more deceptive. Even with the stinging reality that housing values are dropping in many markets, homeownership costs such as taxes, maintenance and financing are still rising much faster than the index."

... ... ...

Gerald Prante, an economist with the Washington-based Tax Foundation, found that median real-estate taxes on owner- occupied housing went from $1,614 in 2005 to $1,742 last year.

``That's an increase of 7.93 prcent, more than double the inflation rate in that time period,'' Prante says.

Those tax levels may sound like nirvana to a New Jersey resident, where median levies are almost $6,000.

... The single-largest expense for most Americans is housing, accounting for as much as a third of household outlays. Yet the Labor Department's Bureau of Labor Statistics only tracks ``owner's equivalent rent,'' or what a home would yield if it was rented out. Rental units and homes are two very different animals, though, and the government casts a blind eye to total homeownership expenses.

The idea that core inflation can be a proxy of real inflation might be as close to science as cargo cults. Only if energy and food are reverting to the means "in a long run" excluding them make any mathematical sense. Regular consumer pays for good and services the price inflated by headline inflation not CPI. And headline inflation is also grossly underestimated. Moreover in the current environment when energy became strategic asset and thus more tightly controlled by national governments that means that chances of energy prices reverting to some means are essentially non-existent. A good argument can be make that energy prices are now sticky and actually were sticky at least last seven years of Greenspan career. Actually Chairman Greenspan was instrumental in establishing CPI as the preferred FED measure (it was "invented" much erlier, but soon forgotten). In a way it can be called Greenspan measure and the idea was very similar of Stalin's idea of elections: "it does not matter how they vote, what matter is who counts votes."  Of course  Chairman Greenspan was expremly gifted potitian, a real master of spin.

The idiotism of using the "absolute" value of CPI are aptly explained in Bloomberg. COM Opinion

Three years later, with crude oil prices hitting a record $78.40 in July, the CPI was rising 4.1 percent. In all that time, the price of something else should have fallen to offset the higher oil prices. The fact that it didn't means our friendly central bank was accommodating the oil-price increase, printing enough money to prevent that from happening.

For the record, the core inflation rate has almost doubled to 2.7 percent in July from 1.5 percent three years earlier.

Recently some soft but solid voices have started to challenge the Fed's choice of a core index, in part because oil prices have been ``volatile'' in one direction -- up -- for most of the last three years.

Stephen Cecchetti, professor of economics and finance at Brandeis University's International Business School in Waltham, Massachusetts, and a former research director at the New York Fed, thinks the core is an unreliable guide.

``Since the goal of policy makers is stable prices overall, including those of food and energy, they should turn their attention to forecasts of headline inflation and stop focusing on core measures,'' Cecchetti wrote in a Sept. 12 op-ed in the Financial Times.

Core inflation has been running consistently below overall inflation for the past decade by about one-half percentage point, he said. The source of the discrepancy is ``in the relative price of energy that has been persistent,'' he said in an e-mail exchange earlier this week. ``Surely, the central bank's objective should not be a biased measure of medium-term inflation.''

As Dr. Marc Faber pointed out:

...study by Tom McManus of Bank of America securities who showed the composition of inflation.

The Bureau of Labor Statistics has calculated that health care inflation in the last ten years or so averaged about 4% per annum. However, from private studies we know that health care costs have risen by around 10% per annum in the last few years. Moreover, whereas the weighting of the BLS's health care expenditures within the CPI is only 6%, health care represents about 17% of consumption, and this, so Bill King points out, according to the Bureau of Economic Analysis of the US Commerce Department.

I think there is no better example to expose the US government's continuous lies about the health of the economy. By understating the rate of CPI inflation the bond market is being fooled and real GDP growth rates artificially boosted since real GDP is nominal GDP less the rate of inflation. So, if nominal GDP increases by 6% and inflation instead of averaging 3% per annum is in fact more likely to average 5% per annum, real GDP growth is not 3% but 1% per year!

As a side, I may add that I have always been skeptical about buying inflation adjusted bonds (TIPS), simply because the yield on inflation adjusted fixed income securities is pegged to the CPI. Since the government will always understate the true rate of inflation the buyer of the TIPS will eternally be shorthanded. Moreover, I think that one day in future, the bond market will finally wake up to the fact that inflation has been understated and sell-off very badly.

In fact, you would have to be the world's greatest optimist (a la Abby Cohen or Larry Kudlow) to buy a US 30-years government bond in US dollars and with a yield of just 4.5% with the view to hold these bonds to maturity. You would have to assume that US inflation will never rise above 4.5% within the next 30 years and that the US dollar's purchasing power will be maintained. Not a likely scenario, in my opinion (short term, however, bonds couldally somewhat more as the economy weakens).

But there is another reason why I started out by talking about markets moving ahead of news. Recently a board member of one of the asset allocation funds, for which I am also an advisor, wanted to double the equity allocation of the said fund based on an economic study he circulated (naturally produced by a self serving investment bank), which showed that the global economy was strengthening and that profit growth would remain strong.

The history of CPI was described in recent New York Tribute article CPI fraud directly linked to subprime credit crisis in the following way:

In 1983, the Bureau of Labor Statistics was faced with an awkward dilemma. If it continued to include the cost of housing in the Consumer Price Index, the CPI would reflect an inflation rate of 15 percent, thereby making the country's economy look like a banana republic. Worse, since investors and bond traders have historically demanded a 2 percent real return after inflation, that would mean that bond and money market yields could climb as high as 17 percent.

The BLS's solution was as simple as it was shocking: Exclude the cost of housing as a component in the CPI, and substitute a so-called "Owner Equivalent Rent" component based on what a homeowner might "rent" his house for.

The result of this statistical sleight of hand was immediate and gratifying, for the reported inflation index quickly dropped to 2 percent. (This was in part because speculators needed to offset their holding costs by renting out their homes while their prices skyrocketed, thereby flooding the market with rentals that pushed down the cost of renting a house or apartment.)

While the BLS was correct in assuming that this statistical ruse would fool the average citizen into believing that inflation was only 2 percent (and therefore be willing to accept a meager 4 percent return on his bank savings), what is remarkable is that the ruse also fooled the bond traders, and apparently continues to do so, leading analyst Peter Schiff to describe these supposed savvy bond traders as the "hormonal teenagers of the capital markets."

The present subprime credit crisis can be directly traced back to the BLS decision to exclude the price of housing from the CPI. It is now clear that the "benign" inflation figures reported over the last 10 years in no way reflected the skyrocketing rise in home prices, with states like California experiencing annual home-price increases of as much as 30 percent. With the illusion of low inflation inducing lenders to offer 5 percent and 6 percent loans, not only has speculation run rampant on the expectation of ever-rising home prices, but homebuyers by the millions have been tricked into buying homes even though they only qualified for the "teaser" rates that quickly escalated to unaffordable levels. As long as home prices continued to skyrocket, buyers could refinance based on the increased value of their equity as collateral; but once home prices stabilized and even declined, many families were forced into foreclosure.

Based on government CPI based inflation calculator $1000 in 1995 was equal in purchasing power to $1336 in 2006. That means that one can safely assume at least 30% deterioration of purchasing ability of dollar for each 10 years or approximately 2.4% a year (in Excel: power(1.336,1/12)=1.024433735).

Also in the US today, government employs 7.7 million more people than does manufacturing. Little wonder we have an $800 billion annual trade deficit when the government sector is larger than the manufacturing sector. That's tells also a lot about the claim of "free market" economy. And with fiat currency the tendency to abuse money printing press by the government is the historical norm. If case of war exceptions are unknown. If you assume that average annual return on 401K account is within the range of  2-6% (2.7% based on some data) then real inflation alone  guarantee negative real return for most 401K owners: you can get back only the amount of money you put into it.   Actually slightly less as 401K owners are indirectly subsiding the government. 

As reflected in the plummeting dollar, many of the 401K gains of the past few years were purely inflation driven, nominal asset price increases -- not real (after inflation) gains.

Government does not publish the statistics as this will reveal far from pretty picture but I suspect that very few, probably less then 20% of owners of 401K account, will get ahead by getting higher then 4.5% returns. See also Inflation conversion factors for dollars 1665 to estimated 2016 to ...  and trends.  Actually factoring in inflation help to see the real picture in many other areas: For example the median hourly wage for American workers has declined 2 percent since 2003.  [Real Wages Fail to Match a Rise in Productivity - New York Times]. If you take into account growing cost of health insurance this is closer to 5% and, for some categories of professionals, 10% decline of wages.  Here is how the this problem was described in Financial Sense  in  June 2005:

In the early 90’s the government realized it had a problem with rising entitlement costs for Social Security, Medicare, and government pensions. These entitlement payments were indexed by the inflation rate each year. With inflation on the rise it meant these costs were rising faster, thus making government deficits much worse. In order to bring the government deficits under control, it would be necessary to bring rising entitlement costs down.

One way to lower entitlements would be to bring the inflation rates down, which would translate into lower Cost of Living Adjustments (COLA). The way to do this was to bring down the rate of inflation. However, this was not done by natural means, but artificially through statistical manipulation. The supply of money and credit began to go parabolic in the 1990s as shown in the graph of M3. The rise in money and credit would mean higher inflation rates. Higher inflation rates would mean higher COLA adjustments, which would lead to bigger deficits.

The solution was to change the way inflation is measured. Media reports began to surface on how CPI was overstated. The real inflation rate was actually much lower according to government and Federal Reserve officials. The Senate Finance Committee appointed the Boskin Commission to study the problem and find a solution. The Boskin Commission published its final report ”Toward a More Accurate Measure of the Cost of Living,“ and submitted its findings to the Senate on December 4, 1996. The Boskin report recommended downward adjustments in the CPI of 1.1%. The CPI, which is used as the basis for COLAs to Social Security and government pensions, if lowered as recommended by the commission, would reduce future entitlement payments as well as impact other government programs. The CBO estimated that by overstating CPI by 1.1% it added $691 billion to the national debt by 2006. By then the annual deficit would rise anywhere from $148 billion to $200 billion annually by overstating the inflation rate. In effect the government was overpaying because the actual inflation rate was much lower.

The Boskin Commission recommended several changes to the CPI index which included:

• develop and publish two indexes

• abandon the fixed-weight formula for CPI goods

• change the weight of items in the index from arithmetic weighting to geometric weighting

• introduce substitutions in the index

• seasonal adjustments to account for price increases that occur on a seasonal basis, which would smooth out the fluctuations

• Reduce prices by quality improvements

The result of their implemented suggestions is the mish mash we have today, which bears no resemblance to reality. The Commissions recommendations had widespread support in the Clinton Administration, a Republican Congress and from financial luminaries such as Alan Greenspan, who was expanding the money supply at a very rapid rate as shown in the graph above.

Substitution
Up until the Boskin/Greenspan initiative surfaced the CPI was computed each month using a fixed basket of goods. That changed after the Boskin Commission. The Bureau of Labor Statistics (BLS) began using substitutions in their monthly computations of the CPI. If beef prices rose, it was assumed that people substituted chicken. If chicken prices rose, then consumers would switch to fish. If all these prices rose, well consumers would become vegetarians or maybe start eating Alpo.

Weighting
In addition to changing items in the index through the substitution principal the BLS also changed the weights of items in the index. Instead of straight arithmetic weightings the BLS began to use geometric weighting. The benefit of geometric weighting is that it automatically gave a lower weighting to those items in the CPI that were rising in price and higher weightings to items in the index that were falling in price.

As an example of how geometric weighting can produce lower values, a recent example from the 90’s bull market will illustrate the point through two Value Line Indexes. The indexes are essentially the same. They are made up of 1650 stocks. One index is arithmetically weighted and the other is geometrically weighted. Between January 1990 and December 2000, both indexes—which include the same stocks—produced totally different outcomes and returns. The geometric index peaked in April 1998. The arithmetic index did not reach its first peak until May 2001. The return from January 1990 to December 2000 was 52% versus over 300% for the arithmetic index. The geometric index peaked in 1998, while the arithmetic index did not reach its first peak until 2001. Since 2001 the arithmetic index has gone on to reach new a new high on 6/17/05, while the geometric index has never recovered from its peak in 1998. This is just one example how geometric weighting can produce lower outcomes not only in stock market indexes but also in inflation rates.

Hedonics
The manipulation didn’t stop there. The bureau also began to adjust prices for quality. This practice became known as hedonics. Hedonics adjusts the prices of goods as a result of the increased pleasure a consumer derives from a product. A few examples will illustrate how removed the index has moved away from reality. Tim LaFleur is a commodity specialist for televisions at the BLS. In December last year he adjusted the price of a 27-inch television set for quality improvements. The 27-inch television set had a retail cost of $329.99. However, he decided the new model, which still sold for $329.99, had a better screen. After putting this improvement through the governments complex hedonic adjustment model he determined the improvement in the picture was worth at least $135! Taking in this improvement he adjusted the price of the TV by $135, concluding that the price of the TV had actually fallen by 29%! [1] The price reflected in the CPI was not the actual retail store cost of $329.99, but $194.99. The only problem for we consumers is that if we went to Best Buy or Circuit City to buy that TV, we would still pay $329.99.

Another example of hedonics at work is the way the BLS treats rising automobile prices. Mr. Reese, a specialist for autos, took a 2005 model car, which went from $17,890 in 2004 to $18,490 in 2005. After adjusting for quality items and making antilock disc brakes standard, the bureau adjusted the actual $600 price increase down by $225. The problem for we consumers is that the price of the car in dealer showrooms was still $18,490.

The Substitution Effect
Substitution also plays a role in reducing the CPI. From 2001-2003 the CPI index fell by 1.6% reaching a low of 1.1%. Wall Street and the Fed were talking about the risk of deflation. Deflation was predicted everywhere in the press. The financial world became fixated over the risk of deflation even though the monetary presses were working overtime, credit was mushrooming, and asset bubbles were inflating in the mortgage, bond, and real estate markets. The reason for the decline was the substitution effect. Instead of using new car prices, which were going up each year, the BLS substituted used car prices, which were falling. In place of exploding real estate prices, the Bureau gave more weight to the price of rents, which were falling as more households bought homes. Rents were given more weight even though 69% of households own a home versus the 31% that rent.

What makes this look even more ridiculous is that in April the National Association of Realtors reported a year-over-year price increase in homes nationally of 15%.

Year Over Year Increase In Household Residential Real Estate Values ($billions) 2000 2001 2002 2003 2004 Through 3Q Cumulative $1,010.3 $1,088.7 $1,197.0 $1,430.5 $1,601.7 $6,328.4 Source: Don't Ask, Don't Tell

One has to wonder as what kind of creativity will be used now that rents are starting to rise as apartment owners remove lease incentives. Perhaps the hedonic models will begin adjusting rising rents downward due to changes in the quality of amenities such as swimming pools, running water, magnificent views of the freeways, or the artistic effects of polluted air in creating colored sunsets.

Many homeowners may not be aware that as a homeowner they receive a fictional income referred to as Owner’s Equivalent Rent (OER). Essentially the BLS samples the price of rents in residential housing to come up with what a homeowner would receive hypothetically if they were to rent their own home. That sounds idiotic to me, since most homeowners would agree the family castle is in many cases a money pit and not a source of income. Unless the home is owned free and clear, most homeowners have cash outgo each month due to mortgage payments, property taxes, utilities, and repairs. As absurd as this concept appears, OER gets the largest weighting in the CPI index of 23% versus actual rent, which gets only a 6% weighting. OER is purely fictional, yet it carries the greatest weight within the CPI index.

Hedonics helps the BLS keep rising prices for goods in the CPI from ever showing up as rising prices. Even though the cost of housing, energy, food, medical bills, prescription drugs, tuition, and entertainment have soared, the government keeps reporting moderate inflation. Hedonics is partially responsible. It has become a convenient and subjective way of removing prices increases from the CPI. The combination of substitution, changing the weight of goods rising in price, hedonics and seasonal adjustments is one reason why the CPI and reported inflation has remained as subdued as it is reported each month. The problem is that these numbers are all fictional and bare no resemblance to what households face each month with their actual budgets.

Seasonal Adjustments
As if these distortions weren’t enough, there are the seasonal adjustments that remove the price increases that occur during certain times of the year, i.e. gasoline prices during the summer driving season or heating oil during the winter. Seasonal adjustments are nothing more than “intervention.” They are designed to remove or scale down volatility or price spikes. The only problem is that price spikes never show up in the CPI. Only price drops get recorded. Price spikes are statistically smoothed away so they never show up. Sharp spikes in oil, gasoline, heating oil, or food get statistically adjusted. This keeps the CPI low. It is why the caller at the beginning of this article was puzzled. What consumers see everyday in real life is so different than what the government reports and the markets accept each month. It is unreality TV.

Spin City

Another way of understating the CPI is the “core rate," which is a nonsensical phrase that is commonly used in the financial world. Whenever the CPI rises, they back out food and energy to give us the core rate, which is much lower. Whenever the CPI rate goes lower, they refer to the CPI rate and not the core rate as they did this month. The CPI fell 0.1% in May from April. It was the first decline in 10 months. The drop was due to falling energy prices. Oil prices started out the month of May at $53.56 a barrel. They fell to $49.65 mid-month before rising back to $52.75 at the end of the month. Did the drop of $.81 really account for a drop in the CPI of 0.10%? If the CPI is as moderate as the Fed claims, then why are they raising interest rates? Could it be inflating asset bubbles, such as real estate, mortgages, and consumption, the imbalances in our trade deficit or expanding annual credit of $2.7 trillion? They haven’t really told us.

Finally, let’s clear up the other nonsensical notion of excluding energy. Energy is essential to industrial economies. It takes energy to extract raw materials from the earth. It then takes energy to manufacture the things we use and consume. It also takes energy to transport the goods we produce. Even the energy we consume takes energy to produce whether it is oil, natural gas, or electricity. Petroleum products contribute about 40% of the energy we use in the United States each year to other products that we never think about.

Transportation accounts for an estimated 67% of all petroleum use in this country. The rest is accounted for by nonfuel products and petrochemical and feedstocks. The list below from the EIA/DOE is not exhaustive, but is illustrative of the many uses of petroleum.

Nonfuel Products

“Nonfuel use of petroleum is small compared with fuel use, but petroleum products account for about 89 percent of the Nation's total energy consumption for nonfuel uses. There are many nonfuel uses for petroleum, including various specialized products for use in the textile, metallurgical, electrical, and other industries. A partial list of nonfuel uses for petroleum includes:

• Solvents such as those used in paints, lacquers, and printing inks
• Lubricating oils and greases for automobile engines and other machinery
• Petroleum (or paraffin) wax used in candy making, packaging, candles, matches, and polishes
• Petrolatum (petroleum jelly) sometimes blended with paraffin wax in medical products and toiletries
• Asphalt used to pave roads and airfields, to surface canals and reservoirs, and to make roofing materials and floor coverings
• Petroleum coke used as a raw material for many carbon and graphite products, including furnace electrodes and liners, and the anodes used in the production of aluminum.
• Petroleum Feedstocks used as chemical feedstock derived from petroleum principally for the manufacture of chemicals, synthetic rubber, and a variety of plastics.

Petrochemical Feedstocks

Petroleum feedstocks have been used in the commercial production of petrochemicals since the 1920's. Petrochemical feedstocks are converted to basic chemical building blocks and intermediates used to produce plastics, synthetic rubber, synthetic fibers, drugs, and detergents. Naphtha, one of the basic feedstocks, is a liquid obtained from the refining of crude oil.

Petrochemical feedstocks also include products recovered from natural gas, and refinery gases (ethane, propane, and butane). Still other feedstocks include ethylene, propylene, normal- and iso-butylenes, butadiene, and aromatics such as benzene, toluene, and xylene. These feedstocks are produced by processing products such as ethane (separated from natural gas), distillates, naphthas, and heavier oils.

Industry data show that the chemical industry uses nearly 1.5 million barrels per day of natural gas liquids and liquefied refinery gases as petrochemical feedstocks and plant fuel. 10 Demand for textiles, explosives, elastomers, plastics, drugs, and synthetic rubber during World War II increased the petrochemical use of refinery gases. Gas byproducts from the production of gasoline are an important source of many feedstocks.[2]”

As shown above from the government's own energy information sheets, the use of petroleum is critical to our modern industrial way of life. Does it really make financial sense to remove it from an inflation gauge that is used to assess the cost of living? Think of what life may become without energy. We may soon find out, if peak oil is really here. With the price of energy at $60 a barrel, excluding its rise from the cost of living is as impractical as it is disingenuous.

Obfuscation

The “core rate” is a fictional concept designed to sooth the financial markets and distract them from the reality of rising inflation. The core rate does not exist anywhere in our economy. It is a fictional concept designed to obfuscate inflation.

The next time you go to the grocery store and experience shock and awe as the checker rings up your shopping cart, ask him or her for the “core rate.” See what kind of look you get. For that matter, when it comes time to make your monthly mortgage payment, instead of making the payment, send a bill to your lender for “owners equivalent rent.” And the next time you pay your taxes in any form, whether income or property, hedonically adjust the bill for the lower quality of government service. If your tax bill went up, just use hedonics to adjust the bill downward. Ah, you might say, "This is impractical. Nobody can ever get away with that." You would be right, but perhaps it is a question we must now ask of government. Somebody should start questioning the reported inflation numbers as our caller did at the beginning of this article. Problems can only be solved when they are acknowledged first. Washington, we have a problem: it is inflation, not deflation.

What needs to be monitored next as the US economy falls into recession and perhaps depression is what happens to money and credit and the price of the dollar. If credit expands and if the Fed or foreign central banks print money to buy our bonds, where will the next asset bubble occur? As long as we live in a world of fiat currencies with no backing to any of the world’s currencies central banks are free to print as much money as they want. There is nothing to stop them from doing so. What we have seen in this new fiat world is that when money and credit expands rapidly there are always sectors that will inflate and others that will deflate. As the technology bubble deflated, three bubbles in bonds, mortgages and real estate took its place. During this time, while new assets bubbles were in the process of inflating as one asset bubble deflated, the CPI fell and was cut in half, giving sway to the argument of deflation. In reality, the only deflation that was taking place was at the BLS in its substitution and hedonic statistical models.

The deflationist’s argument that inflation only takes place during times of war and expanding government budgets isn’t necessarily true. War or expanding budgets aren’t necessary for inflation to occur. Prime examples are Latin America, more recently Argentina, Brazil, Turkey and Russia, as is the Weimar Republic. If deflation takes hold in the US, it won’t be as the deflationists now see it. It will be as result of the currency falling faster than the rise in nominal prices as it occurred in Weimar Germany.

Given the size of mortgage debt and the amount of leverage in our economy and financial system the Fed will not tighten rates in a significant way. The table listed below, taken from the current bond market and John Williams' real CPI, shows just how far behind current interest rates are from real inflation rates.

REAL NEGATIVE INTEREST RATES Real CPI 5.5%
Federal Funds	1 Yr T-Bill	2 Yr Note	5 Yr Note	10 Yr Note	30 Yr Bond
3.25%	3.48%	3.62%	3.73%	3.95%	4.25%
INFLATION DEFICIT
<2.25%>	<2.02%>	<1.89%>	<1.77%>	<1.55%>	<1.25%>

Source: John Williams' Shadow Government Statistics, gillespieresearch.com

As the US debt burden increases with each passing month, the Fed has only one option, which will be to print money. Up until now foreign central banks have relieved the Fed of most of that burden. Foreign central banks have been doing most of the money printing in an effort to sterilize capital inflows into their countries and keep their currencies from appreciating.

This issue has become more serious than is commonly recognized. According to the latest Q1 2005 Z.1 “Flow of Funds” report first quarter non-financial debt expanded a record $2.411 trillion. As Doug Noland reports in his June 10^th Credit Bubble Bulletin, during the decade of the nineties non-financial debt expanded on average $700 billion annually. Blow-off credit creation is now more than three times the pace. [3]

Consider these facts from Doug Gillespie Research:

• During 2004, foreign investors absorbed an extraordinary 98.5% of all Treasury issuance, a net of $357.2 billion acquired, versus a net of $363.5 issued.

• Foreigners absorbed almost as large a proportion of the issuance of US agency securities, 93.7%, a net of $129.6 billion acquired, versus net issuance of $138.3 billion.

• Thus, combined foreign purchases of Treasuries and agencies equaled a stunning 97.2% of total issuance, $486.8 billion, versus $500.8 billion.

• As to the purchase of corporate bonds, foreign investors took down a net of $265.5 billion, 44.7% of total issuance of $594.3 billion.

• In addition to the huge proportion of foreign Treasury acquisitions last year, the Federal Reserve added $51.2 billion to its own Treasury portfolio. This means that during 2004, the Fed and foreign investors absorbed $408.4 billion or about 112.7% of the total issuance of $362.5 billion. Obviously, this had a highly favorable influence, on balance, on Treasury yields during 2004, although an influence hugely lacking in traditional open-market characteristics. [Author's note—this explains the Greenspan conundrum as to why long-term yields fell, while the Fed raised short-term rates]

• As of 3/31/05, foreign investors held a total of $9.723 trillion of US financial assets, up almost $400 billion from revised holdings of $9.326 trillion as of 12/31/04. From 3/31/04, the increase was approximately $1.11 trillion.

• As of 3/31/05, foreign financial liabilities totaled $4.634 trillion, resulting in a net foreign claim against the US of $5.089 trillion.

• For all of 2004, foreign investors acquired a record net $1.255 trillion of US financial assets. During 2005’s first quarter, this figure fell to an annual rate of $1.170 trillion, not materially below last year’s record level.

• During this year’s first quarter, a very high 73.6% of US financial-asset acquisition by foreign investors was in highly marketable (therefore, highly liquid or “exposed”) asset classes. This was up from 66.0% for all of 2004, and equal to the same 73.6% level achieved in 2003. [4]

The following table taken from the same Gillespie report shows just how much of our debt has been acquired by foreigners in the last decade. The Fed has had little need to monetize debt. Foreigners are doing the Fed’s dirty work.

FOREIGN HOLDINGS OF U.S. SECURITIES
Security	03/31/2005	12/31/2004	03/31/2004	12/31/1994
Treasuries	43.0%	42.5%	40.1%	18.3%
Agencies	13.2%	12.7%	11.2%	5.7%
Corp. Bonds	27.3%	26.6%	25.3%	13.4%
Corp. Equities	13.4%	13.0%	12.4%	7.0%
Source: Gillespie Research / Federal Reserve

In effect, the US is exporting its inflation and it will ultimately result in deflation in the rest of the world, which is heavily laden with overcapacity and hyperinflation in the US when foreigners no longer finance our deficits. That is when the end game of hyperinflating our way out of our debt bubble really begins. Unlike the gold standard, there are no self-correcting mechanisms in the global monetary system. The dollar or any other currency for that matter has no intrinsic value. All currencies are fiat and have no limit to the amount of its supply. There can be no dollar short position as some imply, because by its very nature the supply of dollars is unlimited as the above statistics illustrate.

The real risk is what happens when confidence in the dollar wanes as it must. Like the Weimar Republic, which had its currency accepted as a means of payment during the initial stages of inflation, the gig was up once foreigners realized the full extent of the mark’s depreciation. That is when they began disposing the mark and the hyperinflationary stage was set to unfold.

What we can say now is that the US is experiencing real inflation in the economy that is much higher than what is reported (6-8%). In addition to real inflation in the economy, the US has experienced hyperinflation in the financial economy—first in the stock market (the tech bubble between 1995-2000) and then in the mortgage, bond and real estate markets since 2000. If inflation continues to increase as I suspect in the real economy, I can guarantee you it will never show up in the CPI and PPI. Real inflation will be removed statistically through the magic of hedonics, geometric weighting, substitution, and seasonal adjustments.

This whole process of purposefully understating the real inflation rate also keeps real inflation artificially subdued. Think of all of the aspects of our economy that are tied to the CPI. Listed below are just a few examples:

• Wage and labor contracts

• Rents

• COLAs on pensions

• Market interest rates

Labor contract negotiations begin with CPI adjustments. Annual raises at companies are based on CPI changes. Think of how many workers fall further behind in their pay because of an understated CPI. How many landlords are cheated out of their just rents by understated inflation rates? How many retirees are robbed of real increases to their pensions as a result of underreported inflation? What would be the real rate of interest, if bond investors figured out that the real inflation rate was 6% and not 3% as reported by the BLS.

An understated CPI also overstates GDP by not removing the full inflationary impact of pricing from nominal numbers. It also overstates productivity by overstating the numerator part of the equation.

Any debate over deflation or inflation must begin with the truth. By habitually pointing to an understated CPI as proof that inflationary forces remain moderate is disingenuous at best and fraudulent at its worst. The truth is that we are experiencing real inflation rates of 6% in the real economy and hyperinflationary rates in the financial economy in bonds, mortgages, and real estate. When the next downturn comes, it will most assuredly alert investors to keep a sharp eye out for the next asset bubble to hyperinflate. Will it be stocks as occurred in the Weimar Republic, Japan and the US? Will it be hard assets such as gold, silver, and other hard commodities as has occurred throughout all of history when governments inflate?

What we have now is inflation. Forget the CPI, PPI, and the ”core rate.” These are all fraudulent inflation gauges designed to confuse and obfuscate the real inflation issue. There is no such thing as the “core rate.” The core rate doesn’t exist in the real world. Next time you see an increase at the grocery store, the gasoline station, your utility or cable bill, your children's tuition, your property taxes or your dentist's or doctor's bill, ask for the “core rate.” That is when you will be confronted by the reality of its fiction.

P.S. The inflation/deflation debate will be showcased on the FSN network with both sides making their case. Bob Prechter was the first guest, Dr. Marc Faber, and John Williams will be next in line.

P.P.S. A lengthy piece on hyperinflation will be written making its case after my summer sabbatical in August. Part II of "The Great Inflation” coming sometime in late September early October. The piece will be lengthily and may be published in four parts due to the length of its contents. I’ve got Mary worried, because it’s beginning to look like “War & Peace.”

P.P.P.S. As many are fond of making bold predictions, I’ll make a few here.

TEN REASONS FOR HYPERINFLATION

1. Global oil production will peak between 2005-2008. Economic growth ceases to exist as global economies and markets are thrown into chaos and turmoil.

2. The War on Terror escalates into a resource war over oil pitting the great powers the US, China, and Russia in a replay of “The Great Game.”

3. Debt creation and monetization hyperinflates as the government’s deficit spirals out of control with a war and a depression.

4. Foreigners begin to bail out of the dollar setting off a dollar crash.

5. The US puts in place capital controls to corral US and domestic money. The War on Terror will be given as the reason.

6. The government takes over GSEs owning most American mortgages.

7. A national mortgage bailout bill is passed lengthening mortgage payments in an effort to forestall debt defaults. A new restructuring agency will be set up to repurchase impaired mortgages from the banking system and renegotiate terms of the debt to avoid default. The 100-year mortgage is born.

8. A national retirement security act is passed forcing private pensions to buy long-dated zero-coupon government bonds that will be inflated away. The reason given will be for plan protection against bear markets.

9. As the US economy goes into a hyperinflationary depression the rest of the world’s economies follow suit. Money printing on a grand scale occurs in western and Asian economies as governments wrestle and try to satisfy the demands of a social welfare state and an angry, aging populace.

10. As governments hyperinflate and debase their currencies, gold will take on its true role as money rising in value against all currencies. The world will move towards a global currency backed by gold.

I have a few more, but these first ten should do for now.

NEWS CONTENTS

• 20210509* CPI Is A Lie! We can't trust CPI to tell us the truth about inflation by Peter Schiff ( May 04, 2021 , www.zerohedge.com ) [Recommended]
• 20191224 : My "Pickup Truck Price Index" Crushes "CPI for New Vehicles" ( Dec 24, 2019 , www.nakedcapitalism.com )
• 20190614 : CPI and Feds ( Jun 14, 2019 , www.nakedcapitalism.com )
• 20170116 : Even though healthcare spending is nearly 18 percent of GDP, for some reason healthcare comprises less then six percent of the CPI basket ( Jan 16, 2017 , www.nakedcapitalism.com )
• 20151024 : How The U.S. Government Covers Up 72% Inflation Before Your Very Eyes ( Zero Hedge )
• 20150908 : Affinity and Inflation by Paul Krugman ( September 7, 2015 , krugman.blogs.nytimes.com )
• 20150908 : The Old Man and the CPI by Paul Krugman ( July 25, 2015 , krugman.blogs.nytimes.com )
• 20130501 : Why Do We Use Core Inflation? ( Economist's View )
• 20130501 : Owners Equivalent Rent Correction ( 6/18/2009 , CalculatedRisk )

Old News ;-)

[May 09, 2021] CPI Is A Lie! We can't trust CPI to tell us the truth about inflation by Peter Schiff

Highly recommended!

Notable quotes:

"... The CPI is calculated by analyzing the price of a "basket of goods." The makeup of that basket has a big impact on the final CPI number. According to WolfStreet , 10.9% of the CPI is based on durable goods (computers, automobiles, appliances, etc.). Nondurable goods (primarily food and energy) make up 26.6% of CPI. Services account for the remaining 62.5% of the basket. This includes rent, healthcare, cellphone service etc.) ..."

"... The things the government includes and excludes from the basket can make a profound difference in that final CPI number. Back in 1998, the government significantly revised the CPI metrics. Even the Bureau of Labor Statistics (BLS) admitted the changes were "sweeping." ..."

"... In 1998, the BLS followed the recommendations of the Boskin Commission. It was appointed by the Senate in 1995. Initially called the "Advisory Commission to Study the Consumer Price Index," its job was to study possible bias in the computation of the CPI. Unsurprisingly, it determined that the index overstated inflation " by about 1.1% per year in 1996 and about 1.3% prior to 1996. The 1998 changes to CPI were meant to address this "issue." ..."

"... As Peter pointed out, there is a lot of geometric weighting, substitution and hedonics built into the calculation. The government can basically create an index that outputs whatever it wants. ..."

"... Peter said there is a bit of irony in government officials and central bankers constantly complaining about "not enough inflation." ..."

"... They're the ones that are cooking the books to pretend that inflation is lower than it really is. Because what they're really trying to do is get the go-ahead to produce more inflation, which is printing money." ..."

"... And there are other things that hide inflation. For instance, shrinking packaging so there is less product sold at the same price, or substituting lower quality ingredients, or requiring consumers to assemble items themselves. ..."

"... They find different ways to lower the quality and not increase the price, and I'm sure that the government is not picking up on any of that. If the quality improves, yeah, yeah, they calculate that. But they probably ignore all the circumstances where the quality is diminished." ..."

"... The bottom line is we can't trust CPI to tell us the truth about inflation. ..."

May 04, 2021 | www.zerohedge.com

Via SchiffGold.com,

We've been talking a lot about the specter of inflation. Despite the Fed's assurances not to worry because any price increases we're seeing are transitory, some people are indeed worried. A former JP Morgan managing director warned about inflation and echoed Peter Schiff's view that the central bank is powerless to fight it.

And we're seeing rising prices all over the place, from the grocery store to the gas station. Even the government numbers flash warning signs . But as Peter Schiff explains in this clip from an interview with Jay Martin, it's probably even worse than we realize because the government cooks the numbers when it calculates CPI.

The monthly rises in CPI through the first quarter show an upward trend. The CPI in January was up 0.3%. It was up 0.4% in February. And now it's up 0.6% in March. That totals a 1.013% increase in Q1 alone. The question is does this really reflect the truth about inflation? Peter doesn't think it does.

The government always makes changes to their methods of measuring things, whether it's GDP, or inflation, or unemployment. And they always tweak the numbers to produce a better result as a report card. "

https://www.youtube.com/embed/lnPrsBzIZsw

Imagine if students in a school had the ability to change the metrics by which they were graded or the methodology the teacher used to calculate their grades.

Would it surprise anybody that all of a sudden they started getting more As and Bs and fewer Cs and Ds? The government always wants to make the good stuff better, like economic growth, and the bad stuff better, like unemployment or inflation. So, they want to find ways to make those numbers little and the good numbers big."

The CPI is calculated by analyzing the price of a "basket of goods." The makeup of that basket has a big impact on the final CPI number. According to WolfStreet , 10.9% of the CPI is based on durable goods (computers, automobiles, appliances, etc.). Nondurable goods (primarily food and energy) make up 26.6% of CPI. Services account for the remaining 62.5% of the basket. This includes rent, healthcare, cellphone service etc.)

The things the government includes and excludes from the basket can make a profound difference in that final CPI number. Back in 1998, the government significantly revised the CPI metrics. Even the Bureau of Labor Statistics (BLS) admitted the changes were "sweeping."

According to the BLS, periodic changes to the CPI calculation are necessary because "consumers change their preferences or new products and services emerge. During these occasions, the Bureau reexamines the CPI item structure, which is the classification scheme of the CPI market basket. The item structure is a central feature of the CPI program and many CPI processes depend on it."

In 1998, the BLS followed the recommendations of the Boskin Commission. It was appointed by the Senate in 1995. Initially called the "Advisory Commission to Study the Consumer Price Index," its job was to study possible bias in the computation of the CPI. Unsurprisingly, it determined that the index overstated inflation " by about 1.1% per year in 1996 and about 1.3% prior to 1996. The 1998 changes to CPI were meant to address this "issue."

As Peter pointed out, there is a lot of geometric weighting, substitution and hedonics built into the calculation. The government can basically create an index that outputs whatever it wants.

I think this period of "˜Oh wow! We have low inflation!' It's not a coincidence that it followed this major revision into how we calculate it."

Peter said there is a bit of irony in government officials and central bankers constantly complaining about "not enough inflation."

They're the ones that are cooking the books to pretend that inflation is lower than it really is. Because what they're really trying to do is get the go-ahead to produce more inflation, which is printing money."

Peter said the CPI will never reveal the true extent of rising prices.

And there are other things that hide inflation. For instance, shrinking packaging so there is less product sold at the same price, or substituting lower quality ingredients, or requiring consumers to assemble items themselves.

They find different ways to lower the quality and not increase the price, and I'm sure that the government is not picking up on any of that. If the quality improves, yeah, yeah, they calculate that. But they probably ignore all the circumstances where the quality is diminished."

The bottom line is we can't trust CPI to tell us the truth about inflation.

[Dec 24, 2019] My "Pickup Truck Price Index" Crushes "CPI for New Vehicles"

Dec 24, 2019 | www.nakedcapitalism.com

ewmayer , December 23, 2019 at 3:30 pm

My "Pickup Truck Price Index" Crushes "CPI for New Vehicles" | Wolf Street

For the 1990 model year, the base MSRP of the F-150 XLT was $12,986. In the 2020 model year, it's $34,160. That's a price gain of 163%.

Let that sink in for a moment. Over the same period, the CPI for new vehicles (green line, right scale in the chart below) rose just 22%:

Note that from 1990 through 1998, the CPI for new vehicles closely tracked the price increases of the F-150. But this surge in CPI was too disturbing, apparently, and so the CPI methodology was enhanced with aggressive hedonic quality adjustments and other methods to bring CPI down, and it actually fell from 1997 through 2009, even as new vehicle prices were soaring.

Note the inherent class warfare aspect of the dynamic here: Technological advances are inherently deflationary, in that they allow a manufacturing worker to produce ever-more value-add per hour. In a fair world, said workers would share in that increased value-add via salary gains, which would largely offset the price increases of the higher-value-add products they and others produce.

inode_buddha , December 23, 2019 at 3:56 pm

"Note the inherent class warfare aspect of the dynamic here: Technological advances are inherently deflationary, in that they allow a manufacturing worker to produce ever-more value-add per hour. In a fair world, said workers would share in that increased value-add via salary gains, which would largely offset the price increases of the higher-value-add products they and others produce."

I entered the workforce in ~1984, and I have yet to see the workers get a share in anything.

Craig H. , December 23, 2019 at 4:04 pm

In Eric Weinstein's podcast with Tyler Cowen they have an argument about the CPI and the hedonic adjustment. Cowen claims that the finance markets are totally cool with CPI as is and if you think it is messed up then you have the basis for an investment play that will make you a ton of profits if you are correct.

This is the kind of argument that has given rhetoric a bad name for 2500 years.

If you do not have the patience to listen all the way to the end (I am not proud to say that I did) you will learn that Cowen and Weinstein are sure that they have impeccable taste in music. They sound like one of those cartoon characters like Phineas Whoopie the man who knows everything.

https://www.intanibase.com/iad_characters/character.aspx?charID=404

[Jun 14, 2019] CPI and Feds

Jun 14, 2019 | www.nakedcapitalism.com

The right-wing libertarian gold-currency types hate the 2% target. They call the Fed "economic illiterates" for having a 2% inflationary target. After all, "why would anyone think it's a good thing to have prices go up on purpose?"

That is the end of their analysis.

But these boneheads completely miss the point: the 2% target isn't about an intentional effort to create inflation and make things constantly more expensive for people. It's instead about stability.

The 2% target came about almost by accident and fairly unintentionally when it was first set by New Zealand . So this isn't about an intentional effort by the diabolical (((Fed))) to make things more expensive for everyone, or to prevent inflation from becoming lower.

Before, the Fed would just say they want to "lower" inflation, or "increase" inflation without a real target other than to stave off run away inflation. You had chairman like Volker just let the interest rate rip in order to break the back of inflation in a reactionary way. What we ended up with were massive inflationary and deflationary swings and the Central Bankers became tired of it.

So instead of reacting to swings, they decided to just set the target at 2%, that way you are trying to hit the target rather than trying to react to economic indication of rising or lowering inflation.

This isn't all good news. Because when you see the 2% target for what it is, an artificial target that Central Bankers are hell-bent on hitting, you can see why the Fed is getting really anxious these days.

The Central Bankers have pulled out all the tricks out of the bag, QE, ZIRP, rock bottom interest, and even negative interest in Europe, and for a while in 2018 they pretty much hit their 2% target (at least in the US). And we were all styling. Home prices were growing in a stable way. Jobs numbers were great. Stock Market was high. The Trump tax cut scam pumped the economy up even further.

But then December 2018 hit. The sugar high from the Trump tax cut wore off. Wall Street took a 20% bear-market nose dive. Housing prices slowed growth and sales slowed. And now we are seeing manufacturing indexes, initial jobs reports showing things have slowed.

Now they can't keep it at the target and they aren't sure what to do about it. You don't cut interest rates in a strong economy (which is what we supposedly have), but at the same time Wall Street is screaming for further rate cuts. And when Wall Street threw its temper tantrum in December 2018, the Fed rewarded them with putting a stop to the three anticipated rate hikes this year.

If the current CPI stats are an indication of where things are going, it sounds like Wall Street had it right and the Fed had it wrong–the Fed wanted to increase interest rates, which would have had a deflationary effect. Wall Street wanted the cut to get an inflationary effect that helps the market. Wall Street won.

The problem is now that the pause in interest rates didn't have the inflationary effect Wall Street wanted (even though the Fed is still holding on to hope that deflation is "transitory") and so now they are demanding more cuts. At the same time the Fed is scratching its head saying it's "open" to more cuts, but showing some genuine misgivings about cutting rates when they were certain just 7 months ago that rate hikes were what the economy needed.

This is on top of a mixed bag of data suggesting the economy isn't really coming or going at this point, it's just frothy. What we are seeing is paralysis. he only thing left is more cuts. J-Rome knows it.

The other problem is that CPI is also largely a contrived number. It's based on funny math. Don't like the swings in the price of gas? Just take it out of the CPI! Don't like the price of food in there, take it out! Don't like the price of houses, take it out!

If you are trying to manage an economy by hitting an artificial inflationary target of 2% based on artificial inflationary data that doesn't give you the whole picture, an observer could see why you'd be a little confused when your decisions don't lead to your intended outcome.

The reality is for the vast majority of Americans, the price they pay at the pump has direct, immediate and visible impact on their bills, spending and outlook. The price of food does too, and so does the price of the roof over their head. People notice when the price of the big mac extra value meal shoots up a dollar. This is probably also why we have the cognitive dissonance of a "great" economy while people are buried in credit card debt, student loan debt and corporate debt and while a majority ( https://www.cnbc.com/2017/06/19/heres-how-many-americans-have-nothing-at-all-in-savings.html ) of Americans don't have $1,000 liquid money to tap in case of an emergency.

So if CPI is going lower, but CPI doesn't take into account the basic costs of living that are actually extremely volatile and not just smoothly going down, and the Fed is chasing a 2% CPI number that doesn't include these inflationary variables, the Fed could be targeting an inflationary target that is actually deflationary when all the gimmicky math is taken out of the equation.

Now we see why the fed is struggling, CPI is going down. Consumers are feeling the pain of higher prices none-the-less, along with stagnant wages and more debt. What the consumers are experience aren't being taken into consideration by the Fed because those numbers "don't count." You have the market demanding further cuts because the lower the interest rate, the more likely people are to dump their money into the market searching for some investment returns that at least are par with inflation that is probably a lot higher in reality for the average Joe than core CPI lets on.

Why bother saving when you get no return and you can't save anyway because your cost of living is out of control?

No wonder the Fed is being indecisive. They don't want to believe their lying eyes.

Reply ↓

polecat , June 12, 2019 at 6:43 pm

They don't have eyes they have 'receptors' as in like, say .. a cockroach !

OpenThePodBayDoorsHAL , June 12, 2019 at 6:51 pm

Brother free your mind, you're just watching the shadows on the walls of Plato's cave.

Hint: "central" banks are not central at all so how could they have any real control over things like rates and inflation. Start at 18:45:

https://www.youtube.com/watch?v=mVzKdqjtyhw&t=2023s

[Jan 16, 2017] Even though healthcare spending is nearly 18 percent of GDP, for some reason healthcare comprises less then six percent of the CPI basket

Jan 16, 2017 | www.nakedcapitalism.com

fresno dan , January 15, 2017 at 1:59 pm

https://www.peakprosperity.com/blog/106107/mad-hell

"As explained in the Fuzzy Numbers chapter of The Crash Course, even though healthcare spending is nearly 18% of GDP, for some reason healthcare comprises only 5.85% of the CPI basket:
U.S. health care spending grew 5.8 percent in 2015, reaching $3.2 trillion or $9,990 per person. As a share of the nation's Gross Domestic Product, health spending accounted for 17.8 percent.

Does it make any sense to record something that's nearly 18% of GDP as only 5.8%*** of your inflationary experience? Nope, it sure doesn't. Unless your desire is to mask the actual rate of inflation.

In simple terms, just healthcare's share of inflation alone comes to (0.25)*(0.18) = 4.5%. That's more than twice the rate of the supposed total inflation we are experiencing all by itself. Throw in rising rents, car prices, and energy and it's far more likely that an urban consumer is experiencing total price inflation closer to 6% or more per year."

==========================================================================
AND
and although I have posted this many times before, it is always good for a laugh .or a cry .

https://www.bls.gov/cpi/cpifact4.htm
"Although medical insurance premiums are an important part of consumers' medical spending, the direct pricing of health insurance policies is not included in the CPI. As explained below, BLS reassigns most of this spending to the other medical categories (such as Hospitals) that are paid for by insurance. The extreme difficulty distinguishing changes in insurance quality from changes in its price forces the CPI to use this indirect method."

AND
"The US now routinely subjects its citizens to racketeering, charging excessive prices that are increasingly cumbersome to avoid. One example among thousands; a Viagra pill that costs less than $1 in India, costs over $38 in the US"

I am hoping that when masturbatoriums are popping up like Starbucks, and the population ages, the expanding need for viagra will uh stimulate Galbraiths theory of countervailing power, and the stiff increases in the price of viagra will soften.

***I note that the BLS cpi link I use says healthcare composes about 6.5% of the cpi. Of course, the definition is Medical commodities AND medical services, so this may account for the difference .

[Oct 24, 2015] How The U.S. Government Covers Up 72% Inflation Before Your Very Eyes

Notable quotes:

"... The Modern Survival Manual: Surviving the Economic Collapse, ..."

Zero Hedge

scatha

...Look at basic staples eggs, beef, chicken and other foods, rent/housing, education, even transportation and telecommunication cost are "effectively" raising, not to mention medical care, all those things people need to live are raising precipitously.

Even those 1%-ters facing massive inflation forced to buy risky bonds at unbelievable high prices to get any yield at all. The global inflation bubble is here while global demand is dying and commodity nominal prices are collapsing as we speak since with such a high "real" prices everybody expects loss or severe decline of income or profit in the future expressed by a dead body of CapEx and consumption.

On the top of it typical the inflation hiding maneuvers of the retailers producing serving size inflation, quality collapse inflation, component substitution inflation, choice narrowing inflation, package cost and quality inflation, air conditioning, freezing/heating power limitation inflation, shopping experience quality collapse inflation, and other manipulations to keep so called nominal "at the store" price marginal increase of few percent only per year but even that was impossible in 2015 so far.

.. ... ...

More on the scam of evaluating inflation in various forms including CPI I found at:

https://contrarianopinion.wordpress.com/2015/01/29/invisible-hand-and-ot...

nosam

The reduction in product sizes and quality is not so much a measure of inflation as a measure of the declining wealth of the population. People can afford less so the manufacturers change product size/quality to match.

The area I live in now has high inflation but salaries are growing at a faster pace. So I notice a gradual increase in quality and size of products. That said, if you can afford to pay premium prices, you can get good quality pretty much anywhere.

Canoe Driver

American culture is based on financial rape of the working class by a criminal elite. Always was. Part of the system is the illusion fed the common man that his interests are represented by the political class, who in reality are merely business agents for the rich. This illusion dies hard.

ebworthen

"1/2 gallon" of ice cream now 3 pints instead of 4 pints, canned vegetables going to 14 oz instead of 16 oz, "1 pound" bacon now transforming to 12 oz "healthier" packages with a "great price".

I swear to God they are going to sell a "bakers dozen" of 10 eggs instead of 12 for the same price 'ere long.

TeamDepends

It's nuts, sometime over the summer the cans of tomatoes we buy went from 14.75 oz to 14.0. Are they going to start making the cans thicker? Will the cans shrink to G.I. Joe size? Times is tough, people!

Whodathunkit

Buy the imported brand from Europe. They haven't caught on to the smaller size package same amount of $. YET

Escapeclaws

Not true that Europe doesn't have the same problem. Just look at tuna: smaller can, half-full, higher price. Same with everything. Inflation gets going because of corporate greed, which they "justify" by saying their costs are going up. It's a scam through and through. About time someone does a study to analyze when their costs really go up as opposed to them "claiming" their costs are going up.

This inflation is a form of SYSTEMIC PRICE FIXING. Because it is systemic it is not considered price fixing as such from a legal point of view, so they get away with it. Like everything the elite does, they have total control and we are obliged to accept it.

Same story with "gotcha capitalism". They pump a bag of potato chips full of air and then use the excuse that the the chips, which are cozily nestled in the bottom quarter of the bag, are being protected that way. Kind of like the mafia killing one of your kids and then offering to protect the others for a small stipend.

The Yurpeans also pay much higher prices due to how things are packaged. I buy dried beans and pressure cook them, but even there, you cannot buy beans in bulk. Instead you must pay an arm and a leg for a small package. It has gotten to the point that if a bean falls to the floor, I search for it like the widow searching for her lost penny. Pretty soon they will be packaging single beans. I figured that out using mathematical induction.

Eventually, we former middle class people will enjoy the same standard of living as the poor in the third world.

Normalcy Bias

This reminds me of Ferfal's The Modern Survival Manual: Surviving the Economic Collapse, written by a guy who lived through the collapse in Argentina. There are so many paralells to what's going on in the US, they're hard to count. Highly recommended...

http://www.amazon.com/The-Modern-Survival-Manual-Surviving/dp/9870563457

seek

That's "Ferfal." For what it's worth, he's super accessible via his own website forums and a couple of the larger survival forums (I think the ones on ar15.com and ovet at survivalistsboards.com) He's got a recent posting with information from people in the Ukraine that's especially interesting.

If anyone has any doubts about these adjustments, just buy a roll of TP and compare it to the size of the TP holder in any house older than 10 years, it's quite obvious. I have TP that predates the '08 collapse of the identical brand and product line, and it's at least 1/2" wider and wrapped more densely as well.

There is substantial inflation, and it's covered up, and there's no interest being paid by banks but they're charging the average credit card holder something around 14.9 percent. Meanwhile 51% of workers in the US now make under 30K a year. The financial system is absolutely raping the common people in the US, in part due to greed and in part in a desperate attempt to save itself from collapsed caused by their greed accumulated over the past 100 years.

TBT or not TBT

I am shocked, shocked, to find stealth inflation going on in this establishment!

Supernova Born

Every ZH'er should support FerFAL's books (it is the 7.62x51 rifle his "name" is referencing, FAL being an acronym for Fusil Automatique Léger ("Light Automatic Rifle"), and the first three letters are from his first name, Fernando).

Surviving the Economic Collapse is filled with great insights and has proven prophetic.

First thing I think when I see shrinking retail packaging and lowered quality (diluted in the case of SodaStream) was FerFAL said this would happen...

OceanX

Ya'll slam Castro and what he did was kick out the banksters you profess to hate. The way I see it, what happened to Cuba was the retalliation of the banksters. He was blocked from global trade and financing.

In addition, the conservation of their natural resources have preserved Florida's fishing waters!

http://www.amazon.com/Deep-Cuba-American-Oceanographic-Expedition/dp/082...

When therre is an offshore oil spill in Cuba, it will be carried by the Gulf Stream all across the Atlantic and destroy a lot of Florida beach.

[Sep 08, 2015] Affinity and Inflation By Paul Krugman

"...I've been arguing for a while that inflation paranoia is best understood ** in affinity fraud terms. It's true that some people benefit from deflation, but it's hard to make a general case that this is what's driving the phenomenon. And all the CNBC and Zero Hedge followers have been losing money if they believe what they're hearing. To quote myself:

"So who are the people who feel a deep affinity with a crotchety crank? Um, crotchety white guys feeling cranky. The whiteness is, I believe, an important part of the story, as I'll explain in a minute."

September 7, 2015 | krugman.blogs.nytimes.com

Brad DeLong marvels at Peter Schiff insisting * to Josh Barro that US inflation is far higher than the official statistics acknowledge, and hence that the economy is actually shrinking. Incidentally, the independent Billion Prices index - which is internet-based, and places a higher weight on goods as opposed to services including housing - is actually showing deflation right now.

Brad - picking up on me, I think - suggests that it's about affinity fraud. The picture above is from my slides for the Festival of Dangerous Ideas. The figure on the left, for those not familiar with the classics, is Snidely Whiplash, the enemy of Dudley Do-Right; I use him to symbolize the notion that bad economic ideas are propounded by people with an interest in having the government pursue bad policies. On the right is Bernie Madoff, but I'm not thinking of Madoff as much as his followers, who trusted him because they thought he was one of them. That's what affinity fraud is all about.

I've been arguing for a while that inflation paranoia is best understood ** in affinity fraud terms. It's true that some people benefit from deflation, but it's hard to make a general case that this is what's driving the phenomenon. And all the CNBC and Zero Hedge followers have been losing money if they believe what they're hearing. To quote myself:

"So who are the people who feel a deep affinity with a crotchety crank? Um, crotchety white guys feeling cranky. The whiteness is, I believe, an important part of the story, as I'll explain in a minute.

"The basic mindset of the kind of people who pay Ron Paul for his economic advice is pretty clear: they've made some money over the course of their lives, they believe that all of it reflects their own virtue, and they think they know from that experience what it takes to create wealth. They hear that the Federal Reserve is printing money, and it sounds to them like a violation of both the laws of economics and morality - and they surely think of it as a plot to take away their completely earned gains and give them to Those People (hence the whiteness issue).

"You can try as hard as you like to tell such people that monetary policy is mainly a technical problem, that the Fed isn't giving money away, and that predictions of runaway inflation have been utterly wrong; it will make no difference. You can point out that they would have done a much better job of investing if they had listened to the MIT gang; sorry, we're just not their kind of people."

This stuff will never go away.

* http://www.bradford-delong.com/2015/09/i-am-now-swinging-into-the-camp-of-thinking-that-the-only-way-to-understand-this-and-by-this-i-mean-everything-from-peter.html

** http://krugman.blogs.nytimes.com/2015/07/25/the-old-man-and-the-cpi/

[Sep 08, 2015] The Old Man and the CPI By Paul Krugman

"...The basic mindset of the kind of people who pay Ron Paul for his economic advice is pretty clear: they've made some money over the course of their lives, they believe that all of it reflects their own virtue, and they think they know from that experience what it takes to create wealth. They hear that the Federal Reserve is printing money, and it sounds to them like a violation of both the laws of economics and morality - and they surely think of it as a plot to take away their completely earned gains and give them to Those People (hence the whiteness issue).

You can try as hard as you like to tell such people that monetary policy is mainly a technical problem, that the Fed isn't giving money away, and that predictions of runaway inflation have been utterly wrong; it will make no difference. You can point out that they would have done a much better job of investing if they had listened to the MIT gang; ** sorry, we're just not their kind of people."

July 25, 2015 | krugman.blogs.nytimes.com

I don't watch financial news, but CNBC was on in the gym, so I was treated to a long ad from Ron Paul, who wants you to buy his video explaining the coming crisis brought on by loose money. And I found myself thinking about the remarkable fact that there really are people who will buy that video.

After all, Ron Paul has been making the same prediction year after year - in fact, he's been making this prediction at least since 1981! * - and has been wrong year after year. It's hard to think of a doctrine that has been as thoroughly refuted by events as goldbug economics. For a while gold prices did go up, although not for the reasons the goldbugs thought, but now even that has gone into reverse. So why would anyone pay money for this guy's analysis?

Of course, we know why: it's the Bernie Madoff effect, a.k.a. affinity fraud. People believed Madoff because he was their kind of guy, never mind the implausibility of his claims; they believe Ron Paul for the same reason. True, there's no reason to suppose that Paul is deliberately misleading his market – he probably believes his own nonsense. But in terms of the underlying dynamics that makes no difference.

So who are the people who feel a deep affinity with a crotchety crank? Um, crotchety white guys feeling cranky. The whiteness is, I believe, an important part of the story, as I'll explain in a minute.

The basic mindset of the kind of people who pay Ron Paul for his economic advice is pretty clear: they've made some money over the course of their lives, they believe that all of it reflects their own virtue, and they think they know from that experience what it takes to create wealth. They hear that the Federal Reserve is printing money, and it sounds to them like a violation of both the laws of economics and morality - and they surely think of it as a plot to take away their completely earned gains and give them to Those People (hence the whiteness issue).

You can try as hard as you like to tell such people that monetary policy is mainly a technical problem, that the Fed isn't giving money away, and that predictions of runaway inflation have been utterly wrong; it will make no difference. You can point out that they would have done a much better job of investing if they had listened to the MIT gang; ** sorry, we're just not their kind of people.

I'd say it's sad, but I find it hard to feel much sympathy for the marks of this particular scam. Then again, that's probably why they will never, ever listen to what I have to say.

* http://ronpaulsurvivalreport.blogspot.com/2008/02/shocking-news-ron-paul-predicts.html

* http://www.nytimes.com/2015/07/24/opinion/paul-krugman-the-mit-gang.html

[May 01, 2013] Why Do We Use Core Inflation?

Economist's View

kievite

Rate of inflation is generally a political tool not that different in political meaning from the exchange rate of the dollar. Core inflation is good in this respect similar to why religion is good: opium for the masses ;-). Kind of painkiller... Historically core inflation concept was introduced by Burns with the explicit aim to serve as a smokescreen that masks the rampant real inflation.

So there are powerful political forces that support its wide usage as a "politically correct" measure of inflation as during inflation rise it tend undereport inflation providing elite a mean to soother discontent of "wage slaves". Greenspan's attempt to push it probably was not dictated by purely statistical motives, even if we assume that it has some value in smoothing fluctuations on two volatile components. Also question arise, why elimination. BTW why not to try addition, if we value predictive capabilities that much ;-). As stocks are owned by a lot of population via 401K plans why not to include some weighted S&P500 measure of S&P500 dividends as well.

Also why weight in 0%. If for example those two components are weighted 50% will the result be better or worse from pure time series forecasting perspective? Also like in any time series analysis we need to distinguish behavior during historic periods with inflation rise, big drop, not only "business as usual" situations.

Paul Krugman:

Blogging is a bit like teaching the same class year after year; inevitably there are moments when you feel exasperated at the class's failure to grasp some point you know you explained at length - then you realize that this was last year or the year before, and it was to a different group of people.

So, I gather that the old core inflation bugaboo is rearing its head again - the complaint that it's somehow stupid, dishonest, or worse to measure inflation without food and energy prices, often coupled with the claim that the statistics are being manipulated anyway. So, time for a refresher. ...

Hs refresher is here. Let me offer one of my own (from 2008):

Why Do We Use Core Inflation?: There is a lot of confusion over the Fed's use of core inflation as part of its policy making process. One reason for confusion is that we using a single measure to summarize three different definitions of the term "core inflation" based upon how it is used.

First, core inflation is used to forecast future inflation. For example, this recent paper uses a "bivariate integrated moving average ... model ... that fits the data on inflation very well," and finds that the long-run trend rate of inflation "is best gauged by focusing solely on prices excluding food and energy prices." That is, this paper finds that predictions of future inflation based upon core measures are more accurate than predictions based upon total inflation.

Second, we also use the core inflation rate to measure the current trend inflation rate. Because the inflation rate we observe contains both permanent and transitory components, the precise long-run inflation rate that consumers face going forward is not observed directly, it must be estimated. When food and energy are removed to obtain a core measure, the idea is to strip away the short-run movements thereby giving a better picture of the core or long-run inflation rate faced by households. I should note, however that this is not the only nor the best way to extract the trend and the Fed also looks at other measures of the trend inflation rate that have better statistical properties. Thus while the first use of core inflation was for forecasting future inflation rates, this use of core inflation attempts to find today's trend inflation rate [There is a way to combine the first and second uses into a single conceptual framework that encompasses both, but it seemed more intuitive to keep them separate. In both cases, the idea is to find the inflation rate that consumers are likely to face in the future.]

Let me emphasize one thing. If the question is "what is today's inflation rate," the total inflation rate is the best measure. It's intended to measure the cost of living and there's no reason at all to strip anything out. It's only when we ask different questions that different measures are used.

Third, and this is the function that is ignored most often in discussions of core inflation, but to me it is the most important of the three. The inflation target that best stabilizes the economy (i.e. best reduces the variation in output and employment) is a version of core inflation.

In theoretical models used to study monetary policy, the procedure for setting the policy rule is to find the monetary policy rule that maximizes household welfare (by minimizing variation in variables such as output, consumption, and employment). The rule will vary by model, but it usually involves a measure of output and a measure of prices, and those measures can be in levels, rates of change, or both depending upon the particular model being examined.

In general, a Taylor rule type framework comes out of this process ( i.e. a rule that links the federal funds rate to measures of output and prices). However, in the policy rule, the best measure of prices is usually something that looks like a core measure of inflation. Essentially, when prices are sticky, which is the most common assumption driving the interaction between policy and movements in real variables in these models, it's best to target an index that gives most of the weight to the stickiest prices (here's an explanation as to why from a post that echoes the themes here). That is, volatile prices such as food and energy are essentially tossed out of the index used in the policy rule.

The indexes that come out of this type of theoretical exercise often includes both output and input prices, and occasionally asset prices as well. That is, a core measure of inflation composed of just output prices isn't the best thing for policymakers to target, a more general core inflation rate combining both input and output prices works better. ...

Finally, there is also a question of what we mean by inflation conceptually. Does a change in relative prices, e.g. from a large increase in energy costs, that raises the cost of living substantially count as inflation, or do we require the changes to be common across all prices as would occur when the money supply is increased? Which is better for measuring the cost of living? Which is a better target for stabilizing the economy? The answers may not be the same. For a nice discussion of this topic, see this speech given yesterday by Dennis Lockhart, President of the Atlanta Fed:

Inflation Beyond the Headlines, by Dennis P. Lockhart, President, Federal Reserve Bank of Atlanta: ...Let me begin by posing the simple question: What do we mean by "inflation"? The answer to that simple question isn't as simple as it may seem.

The popular treatment of inflation in our sound bite society risks confusing inflation with relative price movements and the cost of living. By cost of living, I'm referring to the costs you and I incur to maintain our level of consumption of various goods and services including essential items such as food, gasoline, and lodging.

Relative price movements occur continuously in an economy as individual prices react to market forces affecting that good or service. Neither relative price movements nor sustained high living costs constitute inflation as economists commonly use the term....

And I think I'll end with this part of his remarks:

Attempts to measure the aggregate rate of price change-no matter how sophisticated-remain imperfect. As a result, when it comes to measuring inflation, judgment is needed to distinguish persistent price movements that underlie overall inflation from the relative price adjustments. Separating the inflation signal from noise involves much uncertainty-especially when making decisions in real time. Discerning accurately the underlying trend is difficult. It is essential for those of us who have responsibility for responding to these trends to use a wide variety of core measures and inflation projections to make the most informed judgment we can.

Feed You can follow this conversation by subscribing to the comment feed for this post.

Edward Lambert:

On the relationship between inflation, unit labor costs and the Fed funds rate... Bottom line is that unit labor costs need to rise faster than inflation for the Fed rate to rise. http://effectivedemand.typepad.com/ed/2013/04/fed-funds-rate-inflation-unit-labor-costs.html

bakho:

Monetary policy is good for controlling core inflation, wage inflation and preventing wage-price spirals.

Monetary policy is too blunt for addressing commodity inflation. Commodity inflation needs to be addressed by a combination of regulatory and fiscal policy.

The Fed should measure the inflation it intends to address, and ignore commodity inflation that the Fed and monetary policy is ill suited to address.

The Blorch:

It's reasonable for the Fed to take responsibility for the core, with energy and food stripped out. After all, if there was a huge crop failure and oil embargo and food and energy prices spiked, what would be the point of blaming the Fed? The Fed can't control the weather or the Mideast so why hold it accountable?

roger gathman

Surely the basket idea is, as it currently stands, delusional. If you tie inflation into the life cycle and you suppose certain norms for the life cycle - for instance, a certain normal incidence of hospitalization and medical care, a certain norm for credentialing (education), a certain norm for shelter, a certain norm for credit, then I think instead of a basket, you have a matrix that captures imperfectly movements in a non-linear system. It is important to understand that people can pay for inflation after it happens - for instance, buying a house with a certain kind of credit that reflects conditions which may not be current, but are nevertheless impossible to escape. The idea that goods are atomized and have such and such a percentage effect on the average household is, I think, simply conceptually invalid.

Owners' Equivalent Rent Correction

6/18/2009 | CalculatedRisk

In a post yesterday, I misread the BLS methodology on calculating Owners' Equivalent Rent.

For a discussion from the BLS of rent measures see: How the CPI measures price change of Owners' equivalent rent of primary residence (OER) and Rent of primary residence (Rent)

The survey question referenced in the above post is for weighting, not price changes.

The price relative for OER is calculated by sampling non rent-controlled renters every six months. These average rents are divided by the sample six months earlier - and converted to a monthly change (by taking to the 1/6th power).

From the BLS document above: "The first step is standardizing the collected (market) rents, putting them on a monthly basis, and adjusting them for a number of circumstances that should not affect the CPI."

To be clear - the BLS is using market rents, not the opinion of homeowners to calculated OER.

I apologize for any confusion.

Caution: Inflation is higher than you think

By W Joseph Stroupe

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.

In response to the criticisms of politically powerful opponents who had a vested interest in a low officially reported and accepted rate for inflation, the transparent and relatively simple Consumer Price Index (CPI) calculation of the inflation-ravaged 1970s and 1980s has evolved into something much more complex that has an array of built-in facilities for moderating the effects of higher prices, those considered and labeled "volatile".

These changes have certainly not resulted in the reporting of higher numbers for inflation, but precisely the opposite. Are the resulting numbers truly representative of the real inflationary picture, or are they merely what government prefers consumers and the markets to believe?

Until the early 1990s, the CPI was a straightforward calculation using the costs of a fixed basket of goods. The identical basket of goods was priced according to prevailing market prices from period to period and the acceleration or deceleration in price represented the rate of inflation for the period. Consequently, this relatively simple calculation served to represent more correctly the costs of maintaining a constant standard of living as prices increased because of inflation.

However, in the early 1990s that transparent method of CPI calculation came under assault from Michael Boskin, then chief economist to the administration of US president George H W Bush, and Alan Greenspan, then chairman of the board of governors of the Federal Reserve System.

Their assertion was that the CPI calculation was much too simplistic and resulted in much too high a measure of inflation. They argued that the calculation needed to take into account the real-world phenomenon of substitution, whereby consumers who cannot afford more expensive items switch to buying the less expensive ones, and that the inflation calculation should switch to tracking the costs of the less expensive items whenever substitution was presumed to occur.

That generally would have required moving from the fixed basket of goods to a variable one, but initially, instead of that move the concept of weighting was introduced into the fixed basket in an effort to approximate the phenomenon of substitution.

Straight arithmetic weighting was gradually replaced by geometric weighting by 1999. In the geometric weighting favored by Boskin and Greenspan, the basket items with recently increasing ("volatile") prices receive less weight while those that decrease in price receive more weight. So the result is a lower overall number for inflation.

It must be noted that the Boskin Commission forcefully presented the case for geometric weighting of the basket items to account for what it clearly saw as the powerful phenomenon of substitution, consumer-switching from more expensive to less expensive items. While the commission focused primarily on the need for changes in the calculation to account "properly" for substitution, its preoccupation with substitution is an admission that substitution is in fact a major factor. Since, in the absence of significant price inflation, consumers would be unlikely to engage in substitution on a meaningful scale, then it is also an indirect but powerful admission that significant price inflation does exist, for why else would consumers switch from more expensive items to less expensive ones?

Thus, by and large, the technical efforts aimed at accounting for substitution in the CPI calculation have diverted attention from the reality of mounting price inflation to the side issue of how consumers are being forced to deal with it.

Another change that has been introduced into the CPI calculation is the use of "hedonics". Hedonics seeks to moderate or account for higher prices by taking into account the increased "pleasure" or satisfaction the consumer derives from a more expensive but supposedly more satisfying product. The introduction of hedonics also has a net effect of lowering the inflation number because the weight of many price increases tends to be nullified in the calculation. However, the attempt to "price down" a more expensive item because it has a higher quality or more features than a reference item is largely subjective, for what is the standard to determine exactly how much the additional quality or features are worth and thus how far down the price effects should be brought?

Very importantly, because of all such changes in the CPI calculation the resulting number for inflation that is reported by government no longer represents the actual costs of maintaining a constant standard of living, as it did in the 1970s and 1980s. Instead, the number more closely represents the costs of holding to an ever declining standard of living.

Thus, critics credibly charge, the official CPI significantly distorts real inflation in the downward direction, making it look much less threatening than it actually is in the real world. Increasingly, and for very good reasons, the man on the street in the United States doesn't buy the official comparatively low 3% core and 5% combined rates of inflation.

As for the number reported for the core rate of inflation, which is arrived at by subtracting out energy and food prices, that number is still achieved using the methods noted above. The core rate calculation seeks to identify whether food and energy prices are having a pass-through inflationary effect upon the rest of the economy.

But since there exist within the calculation a number of factors (as noted above) that all tend to depress the inflation measure, the core measure possesses a distinct sluggishness in representing any pass-through pressures. The core inflation measure is understated and lags significantly behind reality, therefore. What it currently portrays is not commensurate with today's real inflation picture, but rather, at best, with that of many months to a few years ago.

The June 16 comments of Federal Open Market Committee (FOMC) member William Poole, speaking in South Korea, are a warning to the Fed in this regard. He warned that the "formal data" may not be portraying the full inflationary picture, which he says may be worse than the Fed thinks.

The US government has powerful motives for significantly understating the rate of inflation, and knowing that blind trust in whatever it says is foolhardy, a brief examination of its motives is certainly appropriate.

First, US entitlement payments such as Social Security and Medicare are tied to the official CPI. Cost-of-living increases in such payments would seriously balloon the deficit if the official CPI calculation were allowed to revert to its more transparent form. The economic and political ramifications would be enormous.

Second, the Fed is intent on doing all it can to shape inflationary expectations, and the new non-transparent official CPI is a great aid in that effort because it portrays inflation as "not dangerous at all". The official CPI has been a powerful way to lower and to shape inflationary expectations until now.

However, if the Fed really believes its own official CPI, then it is likely to make a huge strategic error and fall behind in the fight against inflation. The official CPI is intended for public consumption only. FOMC members should regard it with suspicion.

The stakes are enormous now as the US economy simultaneously faces slowing growth and mounting inflation, the kind of impending downturn that is making the big Asian economies, Russia, Central Asia and the Middle East think twice about the desirability of continued US global economic leadership. If Washington stumbles in the fight against inflation, either by letting it get out of control or by killing economic growth as it tries to suppress it, the US government may find that the rest of the world's economies won't simply continue to look for solutions and their future fortunes within the framework of the old US-centered global economic order.

With the noteworthy rise of an ever more powerful Asian economic bloc, the simultaneous rise of Russia and the deepening cooperation of all such players and their growing list of oil- and gas-exporting partners in the energy and economic spheres, the old US-centric order is already set to come unglued. The impending US economic downturn, one likely to involve a heavy dose of stagflation along with significant and lasting pain, may be the catalyst that causes the global economic compass finally to swing fully eastward to Eurasia as the new global economic center of power.

W Joseph Stroupe is editor of Global Events magazine at GeoStrategyMap.com, a publication specializing in strategic analysis and forecasting. He is writing a book, New World Order: Multi-Polarity or Asymm-Plexity? with the subtitle The Impending Birth of an Asymmetrical Bi-Polar World Order Characterized by the West under Energy-Based Checkmate by Multifarious East, due for completion late this summer.

(Copyright 2004-06 GeoStrategyMap.com and W Joseph Stroupe. Used by permission.)

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.

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