Does CPI Give a True Inflation Picture?

Many investors may not understand the Consumer Price Index (CPI). But it almost certainly affects them personally. Consider retirees living on a fixed income or employees factoring an inflation rate into their retirement plans. And, of course, we all feel the impact of rising costs at the pump, at the grocery store, and just about everywhere else.

Over the years, there have been several changes to the way CPI is calculated. Some of the most notable:

In 1983, the Bureau of Labor Statistics (BLS) stopped using volatile housing prices in the index, switching to owners’ equivalent rent. This is the amount of rent that could be paid to substitute a currently owned house for an equivalent rental property. This information is obtained by directly asking homeowners the following: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?”

In the late 1990s, there were a couple of meaningful adjustments to the CPI calculation. One dealt with changing product quality, called “hedonic quality adjustment.” It adjusts prices whenever products change due to seasonal change (apparel for instance), quality improvement, innovation, or the introduction of completely new technologies. Consumer appliance and electronics are probably the best example of this; consider how the new tablet computers are upending the PC market.

Here’s an example of an item replacement (per the BLS.gov website); one that’s dear to many an American’s heart – the big screen TV:

cpi-and-inflation-table-a

Item A is a television that is no longer available (remember those big cathode ray tubes?) replaced by a new technology, Item B; those ever-present flat screen TVs. There’s a very large quality improvement and a very large (400 percent) difference in the prices of these TVs. Rather than use the 400 percent increase in price between Item A and Item B, a very convoluted equation is used to determine Item A’s “quality adjusted price.” When this quality adjustment is applied, the ratio of price change looks like this:

cpi-and-inflation-table-b

The resulting price change is a decline of 7.1 percent!
 
The other adjustment to the CPI calculation in the late 90s dealt with product substitution. For example, if steak gets too expensive, individuals substitute hamburger. Steak is simply removed from the typical food basket even though it has been used in the past to track price changes. (That’s the theory, at least, although many people will just ante up the difference and feel the pinch.)

All these changes have been made in an attempt to show a “truer” picture of inflation. As of January 2013, the annualized increase in CPI was 1.6%. On a pre-1983 basis, as calculated by shadowstats.com, CPI was 9.2%!  Thus, the CPI may be understating the real-world cost increases for goods and services.

Regardless of what one may think of these adjustments and the ultimate impact on CPI, the truth is that everyday expenditures may be rising faster than headline CPI. Over the last 10 years headline inflation has increased 26.7%. However, some typical “everyday” expenditures show a different picture: gasoline (all types) +118.8%, one gallon of milk +31.3%, a dozen eggs +64.5%, one pound of ground beef +97.9%, peanut butter +52.0%, white bread +36.5%, and medical care +43.8%.

So, while the government may be telling us that inflation is under control, the impact of “everyday living” is hitting consumers hard. Thus, advisors and investors may need to adjust their inflation assumptions to something higher than CPI, and invest accordingly to meet their needs today and into retirement.

Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.

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  • Jason

    An excellent blog post!

    You mention that in the late 90′s there was a change to the CPI dealing with product substitution where a consumer may buy hamburger instead of steak if the price of steak goes to high. I thought that was the concept of the “chained CPI” that has been kicked around DC lately as a way to blunt the growth of the annual social security cost of living adjustments.

    How would a chained CPI differ from the product substitution changes that are already in place?

    Peter Schiff put a good video up on YouTube a couple months back provocatively titled “Inflation Propaganda Exposed” where he too discusses a number of “everyday” items mentioned above like milk, eggs, beef, ect and how their costs are rising much more quickly than reported by the CPI.

    • http://musserstephen.wordpress.com Steve Musser, Global Marketing Manager, Principal Funds

      Thanks, Jason. To answer your question, CPI-U allows for a modest amount of substitution within item categories (i.e., steak to hamburger). However, it doesn’t account for substitutions across categories (i.e. beef to pork). Chained CPI is designed to account for this type of substitution across CPI categories. Thus, the chained CPI might increase, but not as much as CPI-U.