"Is US Inflation at 8%?"

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:

There is a debate, usually in blogs, and usually with a whiff of conspiracy, about whether our inflation numbers are real, forged, or statistically so skewed as to underrepresent the true rate of inflation by quite a wide margin. I want to pick on this debate in this entry, not so much in support of one of those conspiracy theories, but in support of a more wideranging debate about how we measure inflation….

In the last five years, we have observed a phenomenon that we were not familiar with before, the phenomenon that people “feel” inflation to be higher than officially measured indices tell us. We hear a frequently used explanation: Cognitive science tells us that we give a higher weight to prices we actually see in supermarkets, or at petrol stations, than to prices with no explicit tags on them, such as rents, or telephony. The explanation is that the felt inflation is a purely psychological phenomenon.

You probably all remember that we heard exactly the same argument when we switched from national currencies to the euro. We felt there was substantial inflation, and as it turned out some shopkeepers used the confusion to raise prices, so there was a modest amount of real inflation. But if this had been a change-over phenomenon – we are talking 2002 – it would gone away. It did not.

I myself thought at the time that I was facing a significant rise in costs…. Now you can say: Well this is just you. You are not average. This does not apply to Mr and Mrs Average, and, in fact, I did believe this too.

But Mr and Mrs Average kept on complaining. The raise in euro prices was a factor during the 2005 No Vote in the Dutch referendum on the European constitution. It was almost certainly not the decisive factor, but people mentioned it when asked. In France, in particular, the biggest economic debate today is not the subprime crisis, but the apparent loss of purchasing power, which is economic illiteracy for a “rise in inflation”…..

Experts, and this applies to economists just as much as any engineer or scientist, often dismiss public comments about their subject area with varying degree of snobbish arrogance. This is particularly true about the debate about inflation. It is all in our heads, they say. The numbers don’t lie. The statistics are correct. We are unstable, not the index.

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 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.

There is surely some of this going on in the euro area as well, but the effect is probably less extreme, I think. At the very least, the ECB is not taking oil and food out of the price index, but I think we do use hedonistic pricing too. I have not seen any estimate of German or French inflation in 1980s, or early 1990s terms, and would be very interested if readers could alert me if such estimates exist. My gut instinct tells me that our inflation rate also understates the true rate of inflation, but perhaps to a lesser degree than in the US. But that assertion only cries out to be verified, or to be dismissed.

Even if we are sceptical about some of those numbers, let us at the very least have an honest debate about inflation. 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.

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10 comments

  1. Jojo

    You can’t address a problem until you acknowledge that a problem exists.

    This is the problem with the USA government fudging the statistics. Nothing much of consequence to fix problems can get done until we are up to our ears in alligators, as they say. We need to have honest and accurate reporting and take the medicine early on.

    I know that inflation is much higher than the government reports because I see it in most things that I buy regularly. Also, Costco has been raising prices lately and when that happens, you know there is a problem. For instance, Jarlsberg cheese just increased from $3.99/lb (where it has been for years) to $4.25/lb.

  2. Idaho_Spud

    8% sounds about right. From my vantage point it seems that 100 dollars is the new $20.

  3. anon

    March 13 (Bloomberg) — Want the inside skinny on Federal Reserve Chairman Ben Bernanke’s next moves as he battles to avert recession, bank bankruptcies and the collapse of capitalism? His detailed playbook is freely available from the Fed’s Web site.

    In November 2002, when Bernanke was merely a Fed governor, he gave a speech about “Deflation: Making Sure `It’ Doesn’t Happen Here.” More than five years on, the text provides a step- by-step guide to the Fed’s reaction to the current credit crisis, and hints at the tricks left up the central bank’s sleeve.

    “It’s worth noting that there have been times when exchange-rate policy has been an effective weapon against deflation,” Bernanke said, citing the 40 percent devaluation of the dollar against gold enacted in 1933 to 1934. “The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Monetary actions can have powerful effects on the economy.”

    So, brace yourself for a Fed funds rate close to zero, interest-rate-free loans in exchange for a much wider range of debt collateral, and further dollar weakness.

  4. Anonymous

    The reason John William’s statistics are a mirror copy +x% because that is exactly how he calculates them. As far as I can tell, he took some internal government report that says “this methodology under-reports by x%” and uses that to justify his correction

  5. S

    Think of the implications for the governement if they reported a real number. All the floating rate liabilities suddenly got a lot more expensive (social secuirty etc.). I have always been curious that the TIPS are pegged to CPI index, which is constantly being modified for these adjustments. Inflation prototection really?

    Governement bond market is biggest bubble going. Sester had a great post on the yeld curve conundrum. Anyway you cut it, the US is at the complete mercy of those buying our debt. That and fear I guess.

    The Fed is being slowley relegated to the dustbin as they play whack a mole. At some point they should just let themselves out the side door and let the markets get on with the necessary burnout

  6. Anonymous

    “but the apparent loss of purchasing power, which is economic illiteracy for a “rise in inflation”…..”

    No, Mr. Munchkins, you’re the illiterate. Inflation “rises” by definition. When it declines we call it deflation, bubba.

    Furthermore, “a loss in purchasing power” is clear and comprehensible whereas you often are not with your failed economic mumbo jumbo. It’s time you economists and pundits face up to the shit in your shoe and SHUT THE F*CK UP!

  7. Anonymous

    Meanwhile, back in the UK, non-inflation hits sin taxes:

    Traditional “sin taxes” – duty on alcohol and tobacco – formed a headline-grabbing part of the announcement: the alcohol tax is to increase by 6% more than inflation, with an inflation+2% increase in each of the next four years. This will result in a near-immediate increase of 4p per pint of beer, 3p on cider, 14p on wine, and 55p on a bottle of spirits. A packet of 20 cigarettes will cost 11p more. An additional £950 duty will be charged on the most polluting new cars when they are first bought.

  8. Anonymous

    Where is Warsh now??

    November 21, 2006 (Bloomberg)

    Federal Reserve Governor Kevin Warsh said inflation is too high and there are “clear” risks it won’t slow as investors expect, suggesting he sees price gains as a greater risk than economic growth.

    “Inflation, though down somewhat from its level earlier this year, remains uncomfortably elevated,” Warsh said in a speech at the New York Stock Exchange. “Financial market prices imply that inflation will continue its gradual but persistent downward track during the forecast period. There remain, I believe, clear upside risks to that inflation outlook.”

    Warsh’s views on the economic outlook are consistent with those of his Fed colleagues, based on minutes of the central bank’s Oct. 24-25 meeting, at which it left the benchmark U.S. interest rate at 5.25 percent for a third session. Warsh said today he expects the economy to be “remarkably resilient,” though a “sharp pullback” in housing will hold down growt

  9. Anonymous

    “The evidence is now beyond a reasonable doubt,” said Scott Anderson of Wells Fargo & Co., who was among the 71% of 51 respondents to say that the economy is now in a recession.

    The economists also expressed growing concerns that a 2008 recession could be worse than both the 2001 and 1990-91 downturns. They put the odds of a deeper downturn at an average 48%, up from 39% in the previous survey.

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