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Is Unofficial Inflation Present In The Economy?

By: Repair_Man_Jack (Diary)  |  April 13th, 2011 at 12:15 PM  | 

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In the late 1970’s and early 1980’s, inflation became a crippling detriment to the American Economy. Federal Reserve Chairman, Paul Volker, showed remarkable patriotism for a Democrat. He brought down the hammer athwart this scourge. He raised interest rates through the roof and forced down the price of most consumables to acceptable levels. As a result of Paul Volker’s courage and love for America, the fixed-income consumer was temporarily spared great misery and deprivation.

Of course Fed Chairman Volker’s policy decisions were kryptonite to elected officialdom. They solved a long-term Seldon-Crisis of political economy with little or no concern for short-term public opinion. The primary measure that set off Paul Volker’s alarm system was the CPI (Consumer Price Index). Sadly, the CPI referenced today would not mathematically map to the CPI Volker relied upon back in the day. Therein lies a tale of statistical machination and nerdacious skullduggery.


The base CPI data is collected by the Bureau of Labor Statistics using an exhaustive survey. Details follow below.

The CPIs are based on prices of food, clothing, shelter, and fuels, transportation fares, charges for doctors’ and dentists’ services, drugs, and other goods and services that people buy for day-to-day living. Prices are collected each month in 87 urban areas across the country from about 4,000 housing units and approximately 26,000 retail establishments-department stores, supermarkets, hospitals, filling stations, and other types of stores and service establishments.

(BLS ObCit)

If the BLS just stopped at using the data they got from the surveys, their numbers this month would map to the same CPI that Paul Volker used as a decision point. Yet soon after Volker solved our nation’s inflationary crisis, the mathematical calculation of the CPI underwent alterations that resulted in a reduction of the calculated values.

The old, Volker-Era CPI strictly measured price level. Michael Boskin (Bush I Budget Director) and Alan Greenspan decided that this direct comparison of surveys was too mathematically naïve to accurately measure inflation. Thus, they argued for the inclusion of substitution effects. At this point, they were measuring relative rather than absolute inflation. President Bill Clinton enthusiatically agreed. His BLS put this new measure into effect.

At this point, in order to effectively calculate what I’ll refer to as CPI*, they claim sufficient knowledge of consumer ability and preference to produce an estimator of how people would react to a real change in price level. This dampens inflation measured by CPI* to the extent that a consumer was willing to reduce his utility against a higher price level. The statistical mind-reading implicit in CPI* regrettably camouflages higher price levels.

At this point, the BLS had a data normalization problem. They were forced to account for qualitative preference using quantitative measures. The BLS had no opinion surveys to gauge elasticity of demand for CPI components, so they presumably used prior research to model these effects. They could then use weighting factors to downshift consumer preferences towards cheaper goods as real price levels rose. This mathematically enforced CPI*<= CPI.

Another mathematical conundrum effected CPI*. This happened when they attempted to account for adjustments to the quality of market goods that were not physically measureable with respect to price level. For example, if the government regulated baby cribs to make them safer, the BLS attempted to adjust the price level downward to account for the happiness a new mother would have that her offspring was safer in the new government-approved crib. This got them involved in the very sticky mathematics of quantifying consumer preferences.

Since the BLS had neither the time nor the sample availability to properly compose a Von Neuman preference lottery, they had to guess. They had to guess with no knowledge of how many lower-income mothers would react to the baby crib price increase by making their adorable offspring sleep on the floor wrapped up in a swaddling blanket due to substitution effects. The BLS Hedonic Adjustments are educated guesses, which are probably founded on the best expert opinion available prior to press time. We thus are treated to CPI** (original CPI adjusted both for substitution and hedonic quality factors.)

In fairness to the people who calculate CPI** (or whatever ridiculous notation they use) the cranks and paranoids make outlandish claims. The propriator of Shadowstats.com states that what I call CPI** systematically understates old CPI by 7% per year. I have yet to hear their explanation as to why that hasn’t caused me to live in a cave and hunt wild animals for subsistence yet. However, based upon my own professional training and academic background in Operations Research and Applied Mathematics, I find the current BLS methodologies potentially fallacious for two key reasons.

The most pressing problem comes from the decision to reduce the CPI measures by including a mathematical proxy for economic substitution. I believe that an unbiased estimator of real price level changes is more useful to both citizens and firms than an estimator modified by the BLS’ mathematical attempt to predict substitution patterns. Just tell me the actual change in real price levels and I’ll decide how much hamburger to eat instead of steak. Intentionally rigging up a CPI* that is mathematically forced to behave so that CPI*<=CPI is disingenuous political gamesmanship.

The Hedonic Adjustment problem is more typical of what goes wrong with honest bureaucracy. It’s such a methodological grab-bag of Fuster Cluck that I can’t honestly tell you whether CPI**<=CPI*. My suspicious instincts tell me they play this to political advantage. However, sorting through this dung heap of statistical stupidity is too much work to verify this conjecture. If they don’t have an actual set of Von Nuemann-Morgenstern lotteries to justify claiming that I have ten cents of additional happiness value per gallon of modified clean air gas, they flunk my Intro to Stochastic OR class. Hedonic Adjustments are bravo-sierra.

So we calculate an inflation statistic called CPI. We used to calculate an inflation statistic called CPI. Yet if you attempted to map 1960’s CPI stats to 2010 CPI stats you would find mathematical discontinuities and a ridiculously high margin of error to your estimate. The statistic called CPI does not measure the same thing it measured back before it was dorked with.

This probably means we pay more for the basic necessities of life than our current government is willing to tell us. We now suffer from some level of unofficial inflation that is between 0 and 7%. Is this fatal? Not for me personally. Yet it does contribute to that sense that we just go through an endless cycle of elections to select the next dumb son of a (NSFW) that will stab us all in the back. That is all.

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COMMENTS

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  • Death_of_the_Donkey

    First, there have been several changes to the BLS methods for calculating the CPI over the years, the first major one coming in the early 80′s when owner’s equivalent rent was substituted (for very good reasons) for house prices (http://www.bls.gov/cpi/cpifact6.htm). This actually had an inflationary effect during the 80 as “between 1983 and 2007 the monthly principal and interest payment required to purchase a median-priced existing home in the United States rose by 79 percent, much less than the rental equivalence increase of 140 percent over that same period.” Sure, during the actual housing bubble this missed that inflation, but it has also now missed the deflation of the collapse (which if included would easily have us showing a -5%+ deflation rate).

    As for substitutions, the BLS put out a report on the subject (and hedonic adjustments (http://www.bls.gov/opub/mlr/2006/05/art2full.pdf) that fully explains the methodology AND shows the actual effects of using substitutions and hedonic adjustments on the CPI (the substitution effect is roughly .5% a year and hedonic adjustments are about .005% a year). Let me quote from the report
    “While the switch
    to hedonic adjustment had a significant effect on several of
    the individual item categories, it is important to note that the
    net effect on the All Items index was negligible. This is
    because the direction of these effects varied and the items in
    question had such a small weight. (The total relative
    importance of items for which hedonics have been
    implemented since 1998 is less than 1 percent.) Indeed, the
    net effect of hedonics from 1999 onward (which excludes
    personal computers, but includes televisions and all later
    categories) on the All Items index is estimated to be less than
    1-hundredth of 1 percent per year, specifically +0.005 percent.” (that’s right a whopping .005%).

    The reason the adjustments actually have such a small impact is because of how they are done and to the weight they are done to. Hedonic adjustments are only applied to about 3% of the total basket in CPI and substitutions are mostly applied within the food category (and even then it is only within similar low-level cells (ie ground chuck for ground sirloin, but not ground chuck for an actual steak). The substitutions also can work both ways, as the BLS would also substitute a filet mignon for a flank steak if the price of the flank steak increase by a larger percentage than the price of filet (and remember, they are not fully substituting, they are just adjusting the weights within these categories).

    As for shadowstats (which is garbage), since the site refuses to publish its methodology for anyone to check, we really do not know what he is using (but from the BLS reports I linked to above we know it isn’t substitution, hedonics, or owners equivalent rent). My guess is that what shadowstats is doing, is taking the weights from say 1980 and applying them to today as though we still consume at those percentages (and that things like cell phones and personal computers don’t exist).

    Finally, a good link to check out be: http://www.bls.gov/cpi/cpiqa.htm which explains some FAQ’s about the CPI methodology.

    • skorrent1

      So you use a BLS press release to”debunk” a criticism of BLS methodology. Would you use an EPA pub to convince you that CO2 is a pollutant? Or a USFS document to argue why harvesting is bad for forests? Or,… oh, forget it.

      • Death_of_the_Donkey

        you would see that not only do they cite other independent (and peer reviewed) economic papers on the subject, but that the same methodology has been used and tested in the EU and IMF (in other words, everyone calculates inflation the same way). Also, since the BLS publishes all of their data (right down to what they bought and what it cost in each region), we can easily check their work so to speak. The economists and statisticians at BLS aren’t appointees or have any stake in making the CPI lower/higher, they are bureaucrats whose academic reputations are at stake in making it accurate.

        Finally, if you want to stick your head in the sand and believe a site like shadowstats that publishes no methodology, but says “trust me”, that is fine, but do you really believe that the bond market would be running at a -6% real return?

        • realskinny

          nt

        • http://www.twitter.com/AWG9_yoyo yoyo

          I do have to agree with skorrent1.

          You wrote that, “…not only do they cite other independent (and peer reviewed) economic papers on the subject, but that the same methodology has been used and tested in the EU and IMF (in other words, everyone calculates inflation the same way).”

          This is not exactly helping your debunking of RMJ, in fact it advances skorrent’s, IMO. Let me try it this way, using your words, but changing the subject a bit. Let’s see if this illustrates it better:

          “If you read the document, you would see that not only do they [the IPCC] cite other independent (and peer reviewed) papers on the subject [of Anthropomorphic Global Warming and climate change], but that the same methodology has been used and tested at [East Anglia University, also by Dr. James Hansen of NASA and again at NOAA] (in other words, everyone calculates [climate change] the same way.)”

          Does your argument, changed by me, convince you that AGW/CC is real? Just because “they” say so?

          Just because everyone calculates something the same way, doesn’t make it correct. In fact, BECAUSE the EU and IMF calculates CPI this way is a very strong argument AGAINST it, IMO.

          Respectfully, Greg.

          • scmom

            “Just because everyone calculates something the same way, doesn?t make it correct. In fact, BECAUSE the EU and IMF calculates CPI this way is a very strong argument AGAINST it, IMO.”

            Exactly, The problem we are having with the economy, among other things right now, is the fixation that our Politicians, Academics, and Elites have with the way things are done in Europe. We are not Europe, and do not need to be like them… They are in crisis, economically, politically, security-wise, you-name-it-wise… The LAST thing we want to do is follow their lead.

          • Death_of_the_Donkey

            mathematical formulas just because the Eurpoeans do? Those darn Europeans use pie*r(squared) to find the area of a circle, I guess we shouldn’t use that either?

            The reason everyone uses this method is because it is very accurate, tested, and best approximates what is happening to paid consumer prices across an entire economy. What you seem unable to grasp is that because the formula is an average, that your individual CPI is going to be different from what the CPI says (and so is mine and everyone else’s). Let me try to simplify this even more, I don’t smoke, but the CPI has 1.45% of its weighting in tobacco products, so of course ay inflation in that area wouldn’t affect me, but I would also then have to have an additional 1.45% added to weights in other categories so my personal weight is equal to 100%. CPI is nothing more than an average rate, which by definition would imply that many people are going to experience rates higher and lower than the number they produce.

          • http://www.twitter.com/AWG9_yoyo yoyo

            I thought I was pretty clear as to my meaning.

            I am not taking sides on which CPI calculation is better or otherwise.

            I did not say that we “shouldn’t use mathematical formulas because the ‘peans do.”

            1. What was said regarded your using information from an agency as a response to “debunk this, right now” about an article that calls into question the validity of that very same agency’s information. You are left with a circular argument at best and does not – in any way – debunk the data in the original article. It would be likened as to me saying, “Everything you say is a lie” and you responding with “No it is not, because I say so.”

            2. As to the use of mathematical equations, all I said, in response to you – as an outsider, as a layman – was that if you are trying to advance your argument, by saying that “everyone [IMF, EU]” uses these formulas, and the “everyone” you reference – economically speaking – have failed or are policy train-wrecks, your assertions lose a bit of credibility.

            Honestly, you probably would have “debunked this, right now” in my mind if you had not have mentioned Europe and the IMF in your assertions. But in doing so, you have inserted doubt into your position.

            I am not an economist or statistician so I cannot debunk anything said by either of you.

            Thanks for the discussion!

            Greg

  • hexan

    I don’t care what the BLS prints. It’s garbage.

    In the 1970′s a married head of household could support a family of four in the middle class. Medical care was affordable and insurance was for catastrophic illness. Hardworking youths paid their own way through college with little or no debt.

    Today, it takes TWO incomes to support the same family. Yes, technology has gotten less expensive.

    Everything else has skyrocketed in price.

    Food stamp usage is at an all time high both in numbers and percentage. Housing (absent the last two years) is 100% government supported (GSE’s and FHA). Foreclosures are common even for the employed. Young people struggle to save the 20% initial down payment. Consumer debt is near all time highs.

    Gasoline has gone up and up. Food prices are way up, especially if you account for shrinking package size.

    Kids today leave college with a debt burden unthinkable in past generations, literally decades of repayment. Ever wonder why these young phenoms are all drop outs? Not even a college grad can take a career risk anymore. It’s like indentured servitude.

    Medical expenses are the number one cause of bankruptcy in the US today. Medical care is, without question, unaffordable without insurance. Even that is too expensive for millions of people to afford.

    Did you want to regurgitate that BLS stat about 2% inflation again?

    You can make a pretty cogent argument that the common thread in these markets is the heavy hand of government. I agree. However, let us not forget the relentless printing press the Federal Reserve operates.

    • johnCV

      Statistics can be massaged to support almost anything the operator wants to present.

      A simple glance at actual prices puts the lie to ’0 – 2%’ inflation.

      • Death_of_the_Donkey

        publishes the actual data (down to the individual prices on each item in the basket for each region), the idea that they are massaging the data is laughable.

        Let me explain (if you cannot understand the information in the links I posted above):
        First, the BLS looks at actual expenditures by people (and uses the average of such) to determine the weight of each category in the CPI equation. What this means is that each individual is likely to have their own weighting of the components, but the US aggregate is represented by CPI (in other words, if you spend 20% of your expenditures on gasoline, you will have a higher personal inflation rate than the typical American who spends about 4.3% of their expenditures). This difference is important to note because it shows just how meaningless anecdotes are to this discussion.
        Second, the prices are taken regionally and then averaged into the total CPI (however, you can go to the BLS website and see what the inflation rate for your region was if you are interested). This is important, because for instance milk was measured at an average cost of $3.7/gallon in the midwest, but on $2.85/gallon in the west (Januarry 2011), but these numbers are averaged together.
        Third, while some of the high frequency items (ie gasoline) have gone up, other low frequency items have gone down. In other words if the typical American drives 12000 miles/year in a car that gets 20 miles/gallon, he will purchase 600 gallons of gas during the year ($1500 at $2.5/gallon and $2400 at $4/gallon), but if that same average American has a total of $50k/year in expenditures, then that 60% increase would only amount to a 2% increase in his overall inflation rate.
        Fourth, the BLS measures all of its items by quantity and thus changes in package size have no impact on the inflation rate.

        • skorrent1

          Of the BLS methodology. If they are actually using “actual expenditures” as a measure of CPI, they are ignoring the first response of the consumer to rising prices— namely, to cut back. Money gets tight, so I decide to buy a cheaper used car instead of a new one, and the BLS says, “See, tranportation costs didn’t go up.” That makes sense??

          • Death_of_the_Donkey

            The actual expenditures they are using is for the weighting of various groups, not for the prices themselves. And since expenditures in total have to add up to 100%, then if you did do what you said above, another area of expenditure would have to rise by a like percent. There is no “savings” in the CPI.

          • skorrent1

            I thought you meant it when you said, “while some of the high frequency items (ie gasoline) have gone up, other low frequency items have gone down”. I gave an example of a low frenquency item (buying a car) to compensate for a high frequency increase ($900 per year in gas prices). Do those words mean something else to you?

            Seems to me the whole “substitution” thing suffers from the same problem. I drive to a B&B instead of fly to a resort because food and clothing have gone up. BLS doesn’t care because what they’re measuring is how a family spends its income, not whether prices of things are going up.

          • Death_of_the_Donkey

            You do understand that the total weight of all items has to add up to 100%, so if inflation was rampant you couldn’t avoid it in the equation simply by switching the weights around. Also note, that the major weightings are set every 2 years (it is only within very narrow bands that the weightings will change, ie substitution). And also, remember that your example is anecdotal again, unless that behavior is happening on average, then it is unique to you. Finally, if everyone started to shift to used cars, the prices of used cars would go up and inflation would show up there as well.

            Currently, new cars is weighted at 3.32%, used at 3.0%, and leased at .38%, out of the overall transportation category of 19.4% (this would include everything transportation related for the average American)).

            If you are simply unwilling to understand the methodology and statistics because you just believe in your heart that inflation is rampant, that is fine, but please do not shout some conspiracy theory that the BLS is making up data just to keep inflation low.

          • acat

            Because there’s more than anecdotal evidence out there that shows Cash for Clunkers, which reduced the supply of potential used cars in the market, has caused the price to go up.

            Mew

          • Death_of_the_Donkey

            and the change in price was”

            New Cars and Trucks – (.4%)
            Used Cars and Trucks – 6.0%

            So, while we cannot say (without further analysis) what caused the relative price rise (although my guess is you are exactly correct), used cars definitely went up more than new cars (which actually went down), for a grand disparity of 6.4%.

          • acat

            So, if we’re seeing food prices go up, and we are – even with the funny numbers due to subsitution – that means either demand has gone up or supply has decreased, eh?

            What I mean by “funny numbers”, by the way, is that substitution is a double edged sword. On the one paw, it presents a more accurate picture of what Joe and Jane Sixpack are actually doing – buying cheaper beer and bulk ground chuck instead of pre-packed burgers – but .. at the same time, it obfuscates the actual change in prices.

            The good news is that there are other studies out there that do reflect actual price trends. Can’t find it right now, but there’s a web site out there that tracks the prices of a shopping cart worth of items on amazon.com. That is, it’s both real-time and real-world data. It doesn’t show the changes in Joe and Jane’s activities, but by the same sword, it doesn’t obfuscate price growth over time.

            Mew

          • Death_of_the_Donkey

            if we were seeing true inflation across the board, then you actually couldn’t switch to a cheaper input since they would all be inflating, because the key to remember is that the weights matter. In other words the substitution effect is only useful if inflation isn’t actually rampant (since if beef prices are going up, it won’t matter what cut of ground meat you buy, they will all be going up by the same percent, and it is the percent increase that matters not the nominal level of price).

            As for the amazon basket (I think it is an MIT site), it is severely handicapped (as has been pointed out by economists) that it only captures the things you can find on the net, which isn’t everything (and not all the stuff it captures is a good weight of what is actually purchased by an average American.

          • acat

            A t-bone is not a pack of ground beef.

            The two have a similar nutritional value, same origin, and similar farm-to-market costs associated, but otherwise are dissimilar products.

            Where the CPI loses it is the idea that it’s reasonable to say that Mrs. Jane Chardonay purchasing 3 less steaks and 3 more packs of ground beef is the same.

            Clearly, saying that a t-bone is equivalent to a pack of ground beef is a false statement, and it throws suspicion on the entire process.

            Mew

          • Death_of_the_Donkey

            The CPI does no such thing. Substitution is only done among low level cells (ie it might replace ground sirloin with ground chuck, but will not replace ground beef for steak). Also, because it is about relative price movement, it works both ways, as if a sirloin steak rose by more than a filet mignon rose, it would substitute in the filet.

            So, in fact, the BLS does not say that a pack of ground beef is equivalent to a steak.

          • acat

            That would at least models the substitutions I’d actually make. Ground chuck for ground sirloin I can see, although since ground chuck tends to be fattier, I’d buy more and pack the burgers a little larger since they’re gonna shrink….

            It seems an easy thing to rail against, especially when it’s not well understood, and when the “basket” that it looks at has changed over time.

            I still like the idea of watching a real-time basket, i.e. the MIT/Amazon thing. I agree that it’s got its’ own set of drawbacks – it can’t be a full basket without adding Omaha Steaks or something similar – but .. a comparison between the two could serve to show whether there’s reasonable or “funny numbers” in the mix.

            Thank you for taking the time to explain this.

            Mew

          • Common_Cents

            DotD “(since if beef prices are going up, it won?t matter what cut of ground meat you buy, they will all be going up by the same percent, and it is the percent increase that matters not the nominal level of price). ”

            Do they really capture this granular level of detail to isolate substitution?

          • Death_of_the_Donkey

            There are 8,000 cells in their CPI tables, although what they publish on the web each month is condensed from that. If you are interested, I can link to the page that has all the monthly reports going back to 2000.

          • Common_Cents
          • Death_of_the_Donkey

            http://www.bls.gov/cpi/cpi_dr.htm#2011

            That link will take you to the archive of the monthly reports (they have more details than the annual summaries). They provide the weights, prices of selected goods, and show all of this by city and region too (be mindful, the reports are very lengthy).

  • radioone

    “Figures don’t lie, but liars can figure”.

  • markinidaho

    According to the KISS CPI, all one needs to do is compare this year to last year, or to four years ago, or to ten years ago. Are you better off?

    Nope. MUCH worse off.

    You have an amazing bunch of metaphoric phrases to substitute for profanity in this article.

    The USA has fallen. Thy Kingdom Come.

  • kywrite

    I, a housewife and home entrepreneur, know exactly when inflation hits. It is reflected in the grocery receipts I get back, in fewer school clothes purchased because $200 suddenly doesn’t go as far, in the sudden lack of bargains. It is reflected in my decision to shop at Goodwill instead of Walmart. It is demonstrated to me when I compare sizes of what I have on the shelf to the sizes I’m purchasing at the store — and notice that due to manufacturer shrinkage (a desperate attempt to stave off the necessity of raising prices) the new packages are in odd sizes about ten to seventeen percent smaller than the old ones.

    Thank you, Government. I do not need you to tell me inflation started about a year and a half ago, and escalated right after Christmas. I, and millions of women just like me, are not that stupid. We notice and adjust. Later we vote.

    • jlsankot

      It amazes me that the government feels it absolutely must make everything complicated so they can make the figures show whatever they want them to show with the public being no wiser (at least from my perspective).

      You simply stated the truth and why everyone is now having to make adjustments. I wish the government could state the truth as easily.

    • http://www.twitter.com/AWG9_yoyo yoyo

      Boxes of cereal were not going as far in the house as they had been. One box per meal became the norm (three kids and two parents.) We weren’t eating more, the box sizes shrank but the price stayed the same.

      Having to buy more is the same (if not worse than) having to pay more.

      “Six in one hand, a half-dozen in the other.” It is all the same.

      If the prices are not inflating, then the frequency of the purchases are.

  • wardjh

    The inflation of the 70′s was deemed at the time very high.

    The inflation now is not deemed very high.

    But for the last several years, the Fed considered low inflation at less than 4%. I agree that 4% isn’t much – unless you compound it.

    The Fed has been inventing money – if you or I do it, it is called a felony – and with the invention of so much money what is in your pocket is worth less (or worthless). Prices rise to account for this invented money, and we call that inflation.

    Gold, silver, grains, metals, oil, etc. are at all time highs. Note whenever a statistic about anything in dollars is calculated it has to be done in “constant” dollars. Which is a simple way to say that the money is bogus.

  • chuhoi

    Any body who has been shopping for the household the last three years KNOWS FULL WELL that inflation is significant. How much exactly will be variable, depending on multiple local factors. Not only are prices 5 to 15% higher in the last two years, the “sneaky” inflation of smaller packages and less product within the packages is evident to many of our friends and family. I’m impressed with all the esoterica of statistical analysis as debated above, but talk to anybody on a budget around here, and the consensus is 10% to 15%, regardless of party affiliation or extent of interest in politics. The unemployment numbers are equally suspect. Calling the CBO non-partisan is also getting more laughable month by month. THE PARROT’S JUST TAKING A LONG NAP

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