How We Measure Inflation

I've been talking a lot about inflation lately.  But if you look at the traditional way we measure inflation, the Consumer Price Index (CPI), we are seeing inflation of 1.1% which isn't very much at all.  But like every number and statistic that you hear, you'll learn far more by looking at the methodology that was used to get that number or statistic.

Ostensibly, the CPI is a measure of consumer prices.  That is, an imaginary shopping cart full of goods from many different sectors of the economy (food, houses, cars, clothing, energy, etc.) is brought to the checkout and the price of all those goods is added up.  Then, one month later, the same imaginary shopping cart full of the same goods is brought to the checkout and the price is added again.  By doing some simple math you can figure out what the rate of inflation or deflation is by comparing the change in the price of your shopping cart's contents.  That seems like a very accurate and reasonable way to measure inflation, right?  I think it does.  And that's how the CPI is currently measured.  That's how the CPI was measured before the 1980's.  You see, modern economists and politicians have found some neat new ways to measure the price of those good in the shopping cart.  Let's take a look, shall we?

Alan Greenspan and Michael Boskin argued that changes to the CPI needed to be made for certain items when they became too expensive.  For instance, if the price of steak rose too high they should quit using steak in the CPI measurements and use hamburger instead.  They reasoned that once steak got to a certain price, the consumer would simply eat hamburger instead.  BAM!  Now inflation isn't as high.  Of course, this only shows the rate of inflation measured in terms of maintaining a lower standard of living.  Inflation stayed low on paper but in real life inflation was higher and living standards decreased.

Some years later there was another change that took place.  In addition to substituting cheaper goods for more expensive goods, the CPI started to use geometric weighting.  This means that when the month-to-month (or year-to-year) prices are calculated, more weight is given to prices that are falling, and less weight is given to prices that are rising.  If the price of bread has gone up 10% in the past month, but the price of milk has gone down 10%, then the official CPI measurement will give more weight to milk prices than bread prices, making the rate of inflation appear to be lower than it otherwise would.

More recently, the politicians and economists in charge have come up with a truly amazing new way to measure the CPI.  It's called hedonics, and it shows that these guys will stop at nothing to make inflation appear to be lower than it actually is.  Hedonics adjusts the price of goods for the increased pleasure the consumer derives from them.  That 20% increase in the price of your washing machine?  Well, that isn't going to be included in the CPI because of all the pleasure you get from pushing the fancy electronic buttons instead of turning the loud clicking wheel thing.  When the price of gas goes up due to federally mandated additives, it doesn't raise the inflation rate because the consumer got so much thrill from breathing the fresh air.

I've read that the real inflation rate (measuring CPI with the methods that were in place before all these changes) could be up to 7 or 8% higher than what the official measurements are.  And the Federal Reserve is making decisions based on a 1.1% inflation rate that they want to raise to about 2%.  But because they use such innovative ways to measure inflation, the real inflation rate will have to go up a lot more than 1% in order to get the official number to go up 1%.  I probably sound like a broken record but to me these are all signs that we're heading for an extremely high(er) rate of inflation.

If you're reading this you have access to the internet.  If you're curious about any of this just use the internet to watch the dollar index and commodity prices to see what inflation is doing.  The value of the dollar has been going down for some time and the price of sugar, cotton, corn, etc. has been going up.  When commodity prices (food) go up, and the value of the dollar goes down, you're seeing inflation.  The changes that I've been seeing in these two areas in recent months are significant.

The other day I was talking with someone about what I've been writing and I was told that I'm painting a really bleak picture.  I couldn't argue with that, but I had to clarify that what I'm describing is still the worst case scenario.  But with every passing day, and with every decision the Fed makes, the worst case scenario is looking more and more like the most likely scenario.

Pssst, that's not good.