Misconceptions about the CPI (FR Thread to Prove or Disprove CPI and Shadow Stats)(17page PDF file)

Bureau of Labor Statistics ^ | 2008 | John S. Greenlees and Robert McClelland

[Uncle Miltie]

Addressing misconceptions about the Consumer Price Index

A number of longstanding myths regarding the Consumer Price Index and its methods of construction continue to circulate; this article attempts to address some of the misconceptions, with an eye toward increasing public understanding of this key economic indicator.

The Consumer Price Index (CPI), published by the Bureau of Labor Statistics (BLS), has generated controversy throughout its history. A soon-to-be-published article by Marshall Reinsdorf and Jack Triplett discusses the many past reviews of the methods and data used in the CPI’s construction.1 Beginning with an advisory committee appointed by the American Statistical Association in 1933,2 and continuing through the recent National Research Council panel chaired by Charles Schultze,3 panels and commissions have identified and discussed what is now a well-known set of issues affecting the measurement of consumer prices: consumer substitution behavior, change in the quality of products, the introduction of new types of goods and services, and the appearance of new categories of stores and new channels of product distribution. Given the large number of private and public uses of the CPI, and especially its important role in determining Federal Government revenues and payments, it is natural that each of those issues has been the subject of intense public attention.

Within the past several years....... (Etc.)

[Uncle Miltie]

Please click the link to read the entire article.

I think we know the major proponents and opponents of the CPI here on FR. What I want to do here is to accumulate the Third Party, academic, philosophical, and economic records of arguments in favor or opposing the CPI as currently constructed, and especially whether Shadow Statistics is a more relevant data set.

Let's leave the emotions and personal attacks in the locker room, guys. We know how you point / counter-point each time this comes up. Let's have third parties weigh in.

It is critical to my personal and corporate decision making to determine the validity of the CPI and Shadow Stats. I don't have a dog in this fight, other than to truly understand the relative validity of each approach.

So, let's treat this as our Phd Econ class, and bring facts and arguments. Let's take the conversation up a level, and let's have this string stand as a representative of each camp's best data, proofs and arguments.

I'll moderate, if you don't mind, asking questions of both sides if I personally need clarification. Like I said, I don't have a dog in this hunt.

Thanks!

[Uncle Miltie]

BusinessWeak opened a thread for discussion of this topic here. Feel free to bring this to the thread if it supports your position.

http://www.businessweek.com/the_thread/economicsunbound/archives/2008/09/bls_responds_to.html

[algernonpj]

The CPI per the BLS is “The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services”.

Originally the CPI was designed to measure the cost of a fixed basket of goods, i.e. comparing apple to apples. The rationale behind this was to use a set standard to accurately measure return on investment in relation to inflation, and to accurately measure the standard of living one can afford on a given income in relation to inflation.

The CPI is important because it is used by the Federal Reserve to justify its money printing policies, to set the interest rate on inflation-adjusted bonds known as TIPS, and by the federal government to calculate cost-of-living adjustments (COLA) for the entitlement programs (e.g., Social Security). The more inflation is understated, the higher the inflation-adjusted rate of GDP growth that gets reported. In addition, the CPI influences interest rates, the stock market, and a host of salary and pension negotiations each year

In addition to separating out the cost of food and energy from core inflation, there are several biases understating inflation that have been built into the CPI.

Through the introduction of hedonics, adjustments for quality change, the substitution effect, and geometric weighting, which are soft metrics that are open to political manipulation and can be used to artificially lower inflation, the CPI has changed from measuring inflation in relation to a set standard of living to measuring inflation in relation to a declining standard of living.

In the early 1990’s the ‘substitution effect’ was introduced as a result of the Boskin Report which deemed the fixed basket of goods was irrelevant. For example if the price of steak went up ‘too much’ the price of hamburger, chicken, or Spam was substituted. The CPI morphed from the cost of maintaining a certain standard of living to the cost of maintaining a declining standard of living.

Information about using substitution is found here (Boskin Commission Report). The example used is chicken vs beef.

The actual steak vs hamburger is found here (Panel Sees a Corrected Price Index as Deficit-Cutter). In the same article you'll see references to substitution and quality change.

Over a period of several years, straight arithmetic weighting of the CPI components was shifted to a geometric weighting which gives a lower weighting to CPI components that are rising in price, and a higher weighting to those items dropping in price. Weighting works in conjunction with the substitution effect, quality change, and intervention analysis.

Hedonics aka quality adjustment is my personal favorite. Hedonics adjusts the prices of goods for the increased pleasure the consumer derives from modifications or quality changes to those goods, e.g. if you pay more for gas because of federally mandated additives, the additional cost does not count toward the CPI because of your increased pleasure in breathing ‘cleaner air’.

A Hedonic Price Index for Airline Travel:

Re: Hedonics and Quality Adjustment - QUALITY ADJUSTMENT FOR GASOLINE

"A quality adjustment has been made to gasoline prices used in the January CPI to account for the effects of the mandated introduction of reformulated gasoline in selected areas of the United States. The gasoline index rose 0.4 percent in January, following seasonal adjustment. Without the quality adjustment, it is estimated that this index would have increased 1.1 percent. In those areas required to sell the reformulated gasoline, virtually all of the January price quotes were for reformulated gasoline."

From the 1999 Economic Report of the President: "… reason for the slowing of reported price indexes has been methodological changes to both the CPI and the indexes used in the national income accounts ".

”Intervention analysis seasonal adjustment allows economic phenomena that are not seasonal in nature, such as outliers and level shifts, to be factored out of indexes before calculation of seasonal adjustment factors. (An outlier is an extreme value for a particular month. A level shift is a change or shift in the price level of a CPI series caused by an event, such as a sales tax increase or oil embargo, occurring over one or several months.)” is used to tones down severe upswings.

[algernonpj]

Preemptive response to objections on another thread today (Duty calls):

The direct quote from Chapter 17 of the BLS Handbook of Methods which was referenced:
The CPI was initiated during World War I, when rapid increases in prices, particularly in shipbuilding centers, made such an index essential for calculating cost-of-living adjustments in wages.”

There is no mention of the gold standard, government contracts, wildly swinging prices, or meeting wage costs.

There is however, mention of rapid increase in prices and cost-of-living adjustments in wages.

Quote continued:
“To provide appropriate [arithmetic] weighting patterns for the index, so that it would reflect the relative importance of goods and services purchased by consumers, studies of family expenditures were conducted in 92 industrial centers from 1917 to 1919.” …
“Periodic collection of prices was started and, in 1919, BLS began publication of separate indexes for 32 cities. Regular publication of a national index, the U.S. city average, began in 1921, and indexes were estimated back to 1913.1” [F.Y.I. WW I lasted from 1914 to 1918]

Now back to cost of living adjustments. When one is concerned about ‘cost-of-living adjustments’, a declining standard of living is not what is implied.

The cost-of-living is defined as: The cost of maintaining a certain standard of living. or Price of goods and services required for maintaining an average level standard of living.

A proxy for certain standard of living is a ‘fixed basket of goods’, not one in which the consumer substitutes downward secondary to price increases. In other words, a cost-of-living index = a consumer price index = ‘set basket of goods’ = a set standard of living.

If you peruse the BLS site you will notice the transformation of the CPI from representing the cost of a set standard of living over time to the cost of a declining standard of living over time.

Per the BLS Handbook of Methods, Chapter 17: The Consumer Price Index (CPI) is a measure of the average change over time in the prices of consumer items—goods and services that people buy for day-to-day living.

In the BLS’s ‘Addendum to Frequently Asked Questions’: “Traditionally, the CPI was considered an upper bound on a cost-of-living index in that the CPI did not reflect the changes in buying or consumption patterns that consumers would make to adjust to relative price changes.” Note the introduction of the concept of substitution in response to increasing prices.

If you go to the BLS’s Glossary – cost-of-living-index the transformation is complete:
“ A consumer price index measures a price change for a constant market basket of goods and services from one period to the next within the same city (or in the Nation).”

The definition of a cost-of –living index has been changed:
“A cost-of-living index measures differences in the price of goods and services, and allows for substitutions to other items as prices change. … The CPIs are not true cost-of-living indexes ….”

The issue of changes in consumer tastes is a red herring. Changes in tastes were always accounted for in the BLS’s on going surveys using arithmetic weighting. The transformation of the CPI to representing a declining standard living open to blatant manipulation by the political power that be required the soft metrics of hedonics, quality adjustment, substitution, and using geometric weighting

As to prior revisions, the BLS in its brief overview of revisions lists under ‘The 1998 CPI revision: the sixth comprehensive revision’: Extended the use of hedonic regression to estimate the value of items changing in quality. 1998 was not the beginning of the use of hedonics, rather the extension of the use of hedonics.

IMHO, remember the BLS is from the government and they are there to help you. LOL

[AmusedBystander]

I don’t need the freakin’ government to tell me what inflation is doing. I see it every time I go to the gas pimp or grocery store.

[Uncle Miltie]

Bring your friends, family, and arguments over here, dudes. Keep it FRiendly!

The BLS has attempted to defend against all the Shadow Stats arguments in the linked .pdf. Be sure in your posts that you can overcome their defenses if you wish to defend Shadow Stats.

[Uncle Miltie]

Dude: We’ve seen that post a dozen times. Plus which, the BLS report to which the thread is linked attempts (and does a fair job) of debunking each of your points.

Please go read the BLS arguments, and bring something new.

[Brett66]

So basically they’ve cooked the books. They’ve built their statistics on a foundation of shifting sand which makes them meaningless except in the context to provide political cover in case we need to print more money.

Hey look! We printed more money to pay for excessive government, but your money has the same value!- If you don’t mind eating hamburger instead of steak.

Oh, and ignore the rising food and gas prices, it doesn’t matter.

[Uncle Miltie]

“September 04, 2008

Shadowstats debunked

I’ve yet to find someone who has been able to reproduce the claims made by Shadow Government Statistics about the extent to which government agencies are grossly misreporting the U.S. inflation rate. Apparently, neither has the Bureau of Labor Statistics, as detailed in an article by BLS economists John Greenlees and Robert McClelland in the latest issue of Monthly Labor Review.

First, some of the bolder claims by Shadowstats:

The Boskin/Greenspan argument was that when steak got too expensive, the consumer would substitute hamburger for the steak, and that the inflation measure should reflect the costs tied to buying hamburger versus steak, instead of steak versus steak. Of course, replacing hamburger for steak in the calculations would reduce the inflation rate, but it represented the rate of inflation in terms of maintaining a declining standard of living. Cost of living was being replaced by the cost of survival. The old system told you how much you had to increase your income in order to keep buying steak. The new system promised you hamburger, and then dog food, perhaps, after that....

The BLS initially did not institute a new CPI measurement using a variable-basket of goods that allowed substitution of hamburger for steak, but rather tried to approximate the effect by changing the weighting of goods in the CPI fixed basket. Over a period of several years, straight arithmetic weighting of the CPI components was shifted to a geometric weighting. The Boskin/Greenspan benefit of a geometric weighting was that it automatically gave a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price.

Once the system had been shifted fully to geometric weighting, the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third.

And here’s the response by Greenlees and McClelland:

To begin, it must be stated unequivocally that the BLS does not assume that consumers substitute hamburger for steak. Neither the CPI-U, nor the CPI-W used for wage and benefit indexation, allows for substitution between steak and hamburger, which are in different CPI item categories. Instead, the BLS uses a formula that implicitly assumes a degree of substitution among the close substitutes within an item-area component of the index. As an example, consumers are assumed to respond to price variations among the different items found within the category “apples in Chicago.” Other examples are “ground beef in Chicago,” “beefsteaks in Chicago,” and “eggs in Boston”....

The quantitative impact of the CPI’s use of the geometric mean formula also has been grossly overstated by some, with one estimate exceeding 3 percent per year. It is difficult to identify real-world circumstances under which geometric mean and Laspeyres indexes could differ by such a large amount. The two index formulas will give the same answer whenever the prices used in an index all change by the same percentage. The bigger the differences in price changes, the more the Laspeyres index will tend to exceed the geometric mean. For the growth rate of the Laspeyres index to exceed the growth rate of a geometric mean index by 3 percentage points, however, the differences in individual price changes have to be quite large.

To see this point, consider another very simplified example. Suppose that the CPI sample for ice cream and related products in Boston consisted only of an equal number of prices for ice cream and frozen yogurt and that, between one year and the next, all the prices of ice cream in Boston rose by 8.6 percent while all the frozen yogurt prices fell by 4.2 percent. In that case, the geometric mean estimate of overall annual price change would be 2.0 percent, only slightly less than the Laspeyres estimate of about 2.2%. In order to come up with a difference of 3 index points, one has to assume a much more dramatic divergence between ice cream and frozen yogurt prices than the one hypothesized. For example, if ice cream prices rose 30 percent in one year, while frozen yogurt prices fell by 20 percent, the overall geometric mean index would still rise by 2 percent, but the Laspeyres index would rise 5 percent, for a difference of 3 index points. However, such a large annual divergence would be quite uncommon within CPI basic indexes— between ice cream and yogurt, between types of candy and gum, between types of noncarbonated juices, or between varieties of ground beef. Moreover, for a 3-percentage-point divergence to continue year after year, the divergence between the individual component prices would have to continue to widen. For example, if, by contrast, during the next year ice cream prices increased by the same amount as frozen yogurt prices, then the two index formulas would give the same inflation estimate for that year. Although such a divergence might plausibly occur in one component for 1 year, it is beyond belief that such sharply divergent price behavior would continue year after year across the whole range of CPI item-area components.

Finally, and most importantly, there is rigorous empirical evidence on the actual quantitative impact of the geometric mean formula, because the BLS has continued to calculate Laspeyres indexes for all CPI basic indexes on an experimental basis for comparison with the official index. These experimental indexes show that the geometric mean led to an overall decrease in CPI growth of about 0.28 percentage point per year over the period from December 1999 to December 2004, close to the original BLS prediction that the impact would be approximately 0.20 percentage point per year.

There’s much more in the BLS article on this and related questions such as hedonic price adjustment and owner’s equivalent rent.

Why do people continue to give credibility to an operation like Shadowstats? Now that’s something that I’d like to hear explained.”

http://www.econbrowser.com/archives/2008/09/shadowstats_deb.html

[expat_panama]

Apologies for the flood but this list needs to be in the mix:

Chronology of changes in the Consumer Price Index

Began publication of separate indexes for 32 cities (1919)
Collected prices in central cities periodically.
• Developed weights from a study that BLS conducted in 1917-19 of family expenditures in 92 industrial centers
Reflected the relative importance of goods and services purchased by consumers.
• Collected prices for major groups: Food, clothing, rent, fuels, house furnishings, and miscellaneous
• Limited pricing to items selected in advance to represent their categories
• Began regular publication of a national index, the U.S. city average (1921):
Based index on an unweighted average of the city indexes.
Estimated U.S. city average back to 1913, using food prices only.

The 1940 CPI revision: the first comprehensive revision
• Used weights based on 1934-36 study of consumer expenditures
• Collected prices in the 34 largest cities
• Implemented a weighted average of cities for the U.S. city average CPI
Improvements made between the 1940 and 1953 revisions
• During World War II:
Discontinued the pricing of unavailable items, such as new cars and household appliances
Increased the weight of other items, including automobile repair and public transportation
• In 1951:
Adjusted weights in seven cities using 1947 and 1949 survey of consumer expenditures
Adjusted weights for the 1950 census
Adjusted rent index to remove “new unit bias” caused by rent control
Added new items to the list of covered items, including frozen foods and televisions

The 1953 CPI revision: the second comprehensive revision
• Used weights from a 1950 expenditure survey conducted in central cities and attached urbanized areas
• Refined the target population to include urban wage earner and clerical worker families
• Added a sample of medium and small cities
• Updated the list of items that the index covered, adding restaurant meals
• Added new sources of price data
• Improved pricing and calculation methods

The 1964 CPI revision: the third comprehensive revision
• Based weights on 1960-61 expenditure patterns in metropolitan areas
• Added single-person households to target population: urban wage earner and clerical worker households
• Extended pricing to the suburbs of sampled metropolitan areas
• Updated the sample of cities, goods and services, and retail stores and service establishments
Improvements made between the 1964 and 1978 revisions
• Made quality adjustments for new vehicles at model changeover
• Improved treatment of seasonal items

The 1978 CPI revision: the fourth comprehensive revision
• Added a new Consumer Price Index: the CPI for All Urban Consumers, or the CPI-U
• Renamed the older CPI as the CPI for Urban Wage Earners and Clerical Workers, or the CPI-W
• Used weights from a 1972-73 survey of consumer expenditures and the 1970 census
• Expanded the sample to 85 areas
• Increased minimum pricing frequency from quarterly to bimonthly
• Implemented monthly pricing in the five largest areas
• Introduced probability sampling methods at all stages of CPI sampling:
Used probability selection methods to select the CPI sample items within stores
Eliminated the list of eligible items as virtually all consumer items became eligible for pricing
• Introduced checklists that define each category of spending
• Developed estimates of the CPI’s sampling error and optimal sample allocation to minimize that error
Improvements made between the 1978 and 1987 revisions
• Began outlet and item sample rotation (1981):
Began systematic replacement of outlets and their item samples between major revisions
Implemented new Point-of-Purchase Survey (POPS)
Selected retail outlets with probability proportional to consumer spending therein
Eliminated reliance on outdated secondary-source sampling frames
Began rotating outlet and item samples every 5 years
Began rotating one-fifth of the CPI pricing areas each year
• Introduced rental equivalence concept (January 1983 for the CPI-U; January 1985 for the CPI-W):
Introduced the flow-of-services method, which removes the investment component from homeowner indexes
Discontinued the asset-price approach, which treated the purchase of a home as a consumer good

The 1987 CPI revision: the fifth comprehensive revision
• Used weights from the 1982-84 Consumer Expenditure Survey and the 1980 census
• Updated samples of items, outlets, and areas
• Redesigned the CPI housing survey
• Improved sampling, data collection, data processing, and statistical estimation methods
• Initiated more efficient sample design and sample allocation
• Introduced techniques to make CPI production and calculation more efficient
Improvements made between the 1987 and 1998 revisions
• Improved the housing estimator to account for the aging of the sample housing units
• Improved the handling of new models of vehicles and other goods
• Implemented new sample procedures to prevent overweighting items whose prices are likely to rise
• Improved seasonal adjustment methods
• Initiated a single hospital services item stratum with a treatment-oriented item definition:
Discontinued pricing of the inputs to the index for hospital services

The 1998 CPI revision: the sixth comprehensive revision
• Weights from the 1993-95 Consumer Expenditure Survey and the 1990 census
• Updated geographic and housing samples
• Extensively revised item classification system
• Implemented new housing index estimation system
• Used computer-assisted data collection
• Added the Telephone Point-of-Purchase Survey (TPOPS):
Allows rotation of outlet and item samples by item category and geographic area, rather than by area alone
• Initiated a new housing survey based on the 1990 census (January 1999):
Estimated price change for owners’ equivalent rent directly from rents
• Began using a geometric mean formula for most basic indexes (January 1999):
Mitigates lower-level substitution bias
Reflects shifts in consumer spending within item categories as relative prices change
• Published the CPI-U Research Series
Featured backcastings of all CPI method changes to 1978
Provided revision in cases of methodology change

Improvements since the 1998 revision
Extended the use of hedonic regression to estimate the value of items changing in quality
Directed replacement of sample items in the personal computer and other categories, to keep samples current
Implemented 4-year outlet rotation to replace the 5-year scheme
Began within-outlet item rotation for prescription drugs and other item categories
Implemented biennial weight updates (January 2002):
Separated weight updates from major revisions to keep weights as current as possible
(Weights used in 2002-2003 were based on the 1999-2000 Consumer Expenditure Survey; weights used in
2004-05 were based on the 2001-02 Consumer Expenditure Survey; weights used in 2006-07 were based on
the 2003-04 Consumer Expenditure Survey.)
Increased sample size of the Consumer Expenditure Survey, so that CPI weights can be based on just 2 years of data from expenditure surveys 2 and 3 years previous
Added the Chained Consumer Price Index for All Urban Consumers (C-CPI-U) (August 2002):
Uses more advanced “superlative” index formula (the Tornqvist formula)
Corrects upper-level substitution bias
Began computer-assisted data collection for the Commodities and Services Survey (2002–2003)
Expanded collection of price data to all business days of the month
Began publishing indexes to three decimal places (Jan. 2007)

 

[expat_panama]

Some day the people who bellyache about how they liked the 'old' CPI are going to have to say which old way it is they're talking about.

[JerseyHighlander]

You can perform a ineternet search on “Shadow Stats”+”Hedonic” and get some get hits.

What Williams presents on his website and what he espouses in the media are not the same, he ALWAYS advocates his political ideology in the media.

One of the first truly comprehensive critiques of Williams CPI method is here:
http://www.econbrowser.com/archives/2008/09/shadowstats_deb.html
September 04, 2008
Shadowstats debunked

Williams presented his repsonse to his critics (and specifically the econobrowser critique) a week later in regards to the topic of your post here:
http://www.shadowstats.com/article/special-comment
Response to BLS Article on CPI Misconceptions
JOHN WILLIAMS’ SHADOW GOVERNMENT STATISTICS
SPECIAL COMMENT
September 10, 2008
ShadowStats.com Response to BLS Article on CPI Misconceptions

---

As per my opinion, WIlliams is an interesting character, would be great to sit down and have a few drinks with him and let him really rip into the BLS, Fed, Treasury, Census Bureau, etc.
Personally, looking through his arguments on hedonics, I believe he does indeed overstate CPI. I’m not really qualified to make an arugment on it.

Reading about the Boskin Commission can make your brain fry and kill your soul, so be warned.

Here is one link regarding the little talked about CPI-RS, one of the effects of the Boskin Commission that turns Williams face red when asked about it:
http://share-ws2-md.aarp.org/research/ppi/econ-sec/Other/articles/aresearch-import-326-DD51.html

Men on the Boskin Commission had some doubts about the CPI a decade after the Commission’s final report and implementation,
former member Robert Gordon of Northwestern
The Boskin Commission Report:
A Retrospective One Decade Later*
Robert J. Gordon
http://faculty-web.at.northwestern.edu/economics/gordon/P376_IPM_Final_060313.pdf

---

Trying to track US CPI brings insight for archaelogists trying to understand why Mesopotamians abandoned Cuneiform A record keeping.

[Uncle Miltie]

"I have reproduced Shadow Stats' proprietary annual inflation numbers."

http://www.jparsons.net/antishadowstats/Anti-Shadow%20Stats.xls

"Now you can believe there was a housing bubble, or you can believe that Shadow Stats is trustworthy, but if you believe both you're delusional. Personally, I believe there was a housing bubble and Shadow Stats is full of B.S."

http://bubblemeter.blogspot.com/2011/03/housing-bubble-according-to-shadow.html

[Uncle Miltie]

Commentary on the BLS rebuttal of Shadowstats:

http://www.actuarialoutpost.com/actuarial_discussion_forum/showthread.php?t=149969

[thackney]

Not intended as a thread hijack but do you know why Toddsterpatriot got banned? I was trying to pin him here for input.

http://www.freerepublic.com/tag/by:toddsterpatriot/index?brevity=full;tab=comments

[Uncle Miltie]

Further commentary by a semi-literate observer:

http://amateurassetallocator.com/2008/04/28/is-cpi-manipulated/

[Uncle Miltie]

An interview with John Williams of Shadowstats:

https://www.philstockworld.com/tag/shadowstats/

[Uncle Miltie]

Staying Neutral on Inflation vs. Deflaton
By James Kostohryz Sep 16, 2009 4:30 pm
Use the core CPI as your guide.

There’s been a heated debate in the financial press regarding the prospects for hyperinflation or deflation, with most pundits usually siding strongly with one camp or the other. Nowhere has this debate been more intense than within Minyanville.

I want to go on record saying that I definitely side with… neither.

I’ve been on record several times debunking the notion of hyperinflation or a dollar collapse anytime in the near future. However, I’ve also been on record many times rejecting the doomsday scenarios of the deflationists.

Framing the Debate

Part of the problem with this debate rests in defining what these various terms mean. For example, I can’t recall a single prophet of dollar doom or hyperinflation maven make a specific prediction citing a number or numerical range.

Thus, if the CPI were to rise above 10% per annum, I have little doubt that the mavens of hyperinflation will be declaring victory. And if the US dollar index were to decline another 10% or so, I have little doubt that the prophets of dollar doom with be loudly celebrating.

Similarly, the doomsday deflationists are equally vague in their forecasts. As long as the headline CPI stays below 0%, the doomsday deflationists will likely continue to declare victory.

This will not do. Forecasters need to define what they’re forecasting and be specific about their predictions. For example, the term “hyperinflation” doesn’t have a specific numeric definition. However, various textbooks and other authoritative sources state that the minimum inflation rate that would qualify as hyperinflation would be over 100% per annum. Indeed, most sources that attempt to define hyperinflation cite monthly rates of 20% at minimum.

Similarly, to speak of a 10% or even 20% decline in the value of the US dollar — relative to a particular currency or a basket of currencies — as a “collapse” is nonsense.

Because the vast majority of the US economy is made up services and other non-tradeables, such a decline in the value of the US dollar would hardly be felt at all at the consumer price level.

Furthermore, such a decline would actually be quite positive for the US economy, as it would contribute to the lowering of the current account deficit — a problem that is at the heart of many important economic problems that the US faces, including excess indebtedness, sluggish job growth, and income inequality.

So a 10% to 20% decline in the foreign exchange value of the US dollar is hardly something that should generate the sort of panic that prophets of dollar doom have been attempting to incite — rather it would be something to be welcomed.

What about the doomsday deflationists? They’re similarly vague in their predictions.

Admittedly, I’ve heard few speak of “hyper-deflation.” So presumably, any inflation rate below 0% would satisfy their criteria.
However, this will also not do. Predictions of deflation need to be specific. For example, many in the deflation camp seem to view today’s CPI figure of -1.5% as confirmation of their views regarding deflation.

However, what should we make of the fact that the core CPI — which encompasses the vast majority of goods and services — is still rising at a +1.4% per annum pace?

The Ideological Mindset

The truth of the matter is that many of the most ardent participants in the debate on inflation versus deflation tend to exhibit an ideological mindset.

There are several traits that tend to characterize such a mindset.

1. They tend to see things in terms of extremes — as black or white; all or nothing.

2. They tend to disregard empirical data, or to “explain away” the data that’s not favorable to their point of view.

Let me cite some examples: A few years ago, the ideologues of hyperinflation were ardently arguing that despite the fact that the CPI was not rising, there really was inflation. One statistic they liked to cite was the growth in the money supply.

The funny thing is that ever since the growth in the various money-supply aggregates started to decelerate — and even contract in some cases — the ideologues of inflation stopped citing this metric.

Similarly, the ideologues of inflation constantly used to cite “asset price inflation” in property values and stock prices as evidence that there really was inflation, despite the fact that there was little or none reflected in the CPI.

However, strangely enough, in the last couple of years since property values and the stock market have been falling, the ideologues of hyperinflation have apparently suffered a case of amnesia and no longer seem to think those metrics are of any importance.

Indeed, when all else fails and the ideologues of hyperinflation are unable to find any empirical support for their claims, they tend to resort to citing highly questionable alternative statistics such as those concocted by Shadowstats.

Despite clear evidence of flat to falling consumer prices and collapsing asset prices, the ideologues of hyperinflation adamantly insist that there really is significant inflation, but the evil government is hiding it from us.

How do you have a constructive argument with people that either refuse to argue on the basis of empirical statistical data or that simply make up their own data?

Similarly, the advocates of deflation have had a bonanza in the past year citing falling stock prices and property values as evidence of massive deflation. Yet, I haven’t been hearing any of these very pundits talking about inflation rather than deflation now that stock prices are exploding and property values are rebounding.

And again, I don’t see many of the ideologies of deflation acknowledging that the core CPI has never once reflected deflation during the recent crisis.

My Own Position

So, let me make my own position clear.

I believe that the core CPI is, in general, the best (although not the only) metric of inflation to monitor given the fact that food and energy prices tend to be volatile. Furthermore, food and energy prices are often driven more by localized supply-side resource constraints than the sort of generalized demand-pull dynamics characteristic of a truly inflationary environment.

It’s my expectation that price levels, as defined by the core CPI, will remain within a range of 1.00% to 5.00% for the foreseeable future. Furthermore, it’s my expectation that disinflationary momentum is probably bottoming out, and that in the short to medium term, core inflation will tend to revert toward its recent norm between 2.0% and 3.5%.

Exactly how much core inflation rebounds from its current level of +1.4% depends entirely on the strength of the rebound in global growth. Liquidity is relatively abundant; therefore a stronger-than-expected global growth spike that puts pressure on certain short-term-supply-constrained goods and services such as natural resource commodities is certainly possible.

However, even in such a scenario, massive overcapacity in most industries, coupled with widespread unemployment, will tend to put an upper lid on any generalized inflation that would propel the core CPI above 5%.

Hyperinflation, although a theoretical possibility that can’t be ruled out in the long term, is an extremely remote possibility in the short to medium term (defined as the next two years).

In terms that might be familiar to fans of the Austrian school, under current circumstances, excess liquidity combined with a surge in aggregate GDP growth (characterized by growth differentials among sectors of the economy) may cause relative price distortions and various concomitant ills. However, it’s unlikely to cause aggregate level hyperinflation.

Disinflation is the term I use most often to describe the economic environment with respect to aggregate prices during the past three decades, including the past year. And further disinflation is certainly a possibility in an environment of weaker-than-expected global growth.

However, massive fiscal and monetary stimulus in the US and elsewhere around the world will also put a floor on the extent of any deflation.

Governments and central banks in the US and around the world have considerable ability through a whole arsenal of measures to prevent deflation and it’s evident from the policy responses of the past year that officials around the world are determined to employ whatever monetary and/or fiscal mechanisms necessary to prevent a severe deflationary scenario analogous to the Great Depression.

Thus, for this reason, and the stickiness of modest inflationary expectations that have been ingrained in the psychology of the US population, core CPI inflation is unlikely to dip far below 0% in the foreseeable future.

Conclusion

It’s my expectation that disinflationary and deflationary pressures are subsiding and are quite likely to have bottomed out for the foreseeable future.

In particular, positive global growth surprises and concomitantly recovering asset prices are likely to create pockets of modest price increases in some sectors of the economy, which should be reflected in a reversion of aggregate core CPI inflation to recent historical norms between 2.5 and 3.5%.

However, because of massive overcapacity, unemployment, and the stickiness of inflationary expectations, a spike in core inflation above a modest 5.00% is unlikely, even if for no other reason than the fact that bond “vigilante-ism” would cause a spike in interest rates that would kill the incipient economic recovery, and with it, any major momentum in demand-side inflationary pressures.

In the end, the extremely heated debate between the mavens of hyperinflation and the doomsday deflationists is probably nothing more than a great deal of sound and fury signifying nothing.

http://www.minyanville.com/businessmarkets/articles/inflation-deflation-hyperinflation-CPI-dollar-minyanville/9/16/2009/id/24532

[JerseyHighlander]

Prce the housing bubble in physical gold and you come to the same conclusion, “”Now you can believe there was a housing bubble, or you can believe that market pricing of gold denominated in US Dollars is trustworthy, but if you believe both you’re delusional.”

I can’t find the US property priced in Gold blog post, so here’s a UK property priced in gold blog post and a Aussie property priced in gold blog post:

http://www.mountaininvestor.com/blog/?p=278
Property Priced in Gold
Posted on 13 April 2011 by BenM

When priced in gold property prices are down 69% from their peak in 2007

Property prices may only be down 14% when priced in British Pounds, however when priced in ‘real’ money i.e. gold, we see that property prices are actually down 69% from their peak in the summer of 2007.

---

http://www.bullionbaron.com/2010/09/australian-property-priced-in-gold.html

[Uncle Miltie]

Good graphs and arguments here:

http://nowandfutures.com/key_stats.html

M3 is back
We did some sleuthing and data extraction and put M3 back together from various weekly Federal Reserve reports that are still available.
1.The formula we’re using has five 9s correlation to the original data back to 1980.

2.There is only one missing element that is apparently no longer available (Eurodollars) and an adjustment has been applied to generate it. Its only about 3% of total M3 so should not have a material effect on the total.

Here is our article on M3b, which details our work and notes the sources for the data. Note that as of Nov. 10, 2006 the Eurodollar estimation formula has changed - see the article for details.

John Williams monthly reconstruction of M3 is here. Ours tends to be more volatile than his, partly because it’s weekly and partly because of our differences in calculating the repo and Eurodollar component of M3.

Finally and to put M3 into proper perspective with inflation (as measured by CPI without lies), the M3 and M2 strong inflation link is virtually unquestionable. The longer term inflation picture is clear, although M2 shows a pause and likely temporary disinflation as of 2008. Certain bloggers are incorrect and have continually avoided these facts and the linked chart.

[Uncle Miltie]

http://bonddad.blogspot.com/2010/01/no-virginia-government-isnt.html

Tuesday, January 5, 2010
No Virginia, the Government Isn’t Manipulating Economic Statistics

Money Quote:

“If the blue line on the shadowstats graph were the correct inflation measure, bond yields would be at least 400 basis points higher. Why? If shadow stats were correct, then bond investors would have been losing money for most of the 2001-2008 period because inflation was higher than the stated interest rate on the 10-year Treasury bond. Simply put, investors would not put up with that and instead would have sent yields far higher for the last decade. Yet they did not. That tells us that Shadow stats CPI number is wrong.”

[Uncle Miltie]

(Frankly, I think it is entirely possible that bond investors actually did lose money for most of the 2001 - 2008 period.....The human herding instinct and is strong)

[Uncle Miltie]

Official US Deficit Put At Staggering $202 Trillion

Posted by EU Times on Aug 25th, 2010 // 7 Comments

The Congressional Budget Office (CBO) forecasts the U.S. budget deficit will hit $1.3 trillion this year. An astronomical figure, to be sure, but that’s lower than was projected in March. It’s also less than last year’s record $1.41 trillion deficit, which was close to 10% of GDP.

And, that’s the good news.

As the deficit grows so does the national debt, which is currently more than $13.3 trillion, according to official figures.

But the situation is actually much, much worse, according to Boston University economics professor Laurence Kotlikoff.

“Forget the official debt,” he tells Aaron in this clip. The “real” deficit – including non-budgetary items like unfunded liabilities of Medicare, Medicaid, Social Security and the defense budget – is actually $202 trillion, the professor and author calculates; or 15 times the “official” numbers.

“Congress has engaged in Enron accounting,” says Kotlikoff, who recently penned an op-ed for Bloomberg entitled: The U.S. Is Bankrupt and We Don’t Even Know It.

Yet, the debt market continues to have an insatiable appetite for U.S. Treasuries; heading into Monday’s session, the yield on the 30-year Treasury bond (which moves in opposition to its price) was at its lowest level since April 2009.

Kotlikoff says that’s because the market is focused on the “mole hill” of official debt. In time, the U.S. will have a major inflation problem to rival that of Germany’s post World War I Weimar Republic, he predicts. “We have to think about the fact that unless the government gets its fiscal act in order we’re going to have the government printing lots and lots money to pay these enormous bills that are coming due over time.”

America is in need of major reform of the health-care, retirement, tax and financial system, Kotlikoff continues. “We need (to perform) heart surgery on this economy, not putting on more band-aids which is what we’ve been doing.”

Barring that, your hard-earned dollars will soon be worthless, he declares.

[Uncle Miltie]

Bringing Professor Gordon’s synopsis to the fore:

The Boskin Commission Report: A Retrospective One Decade Later*

Abstract
This paper provides a retrospective on the 1996 Boskin Commission Report, Toward a More Accurate Measure of the Cost of Living, and its famous estimate that the CPI in 1995-96 was upward biased by 1.1 percent per year. The paper summarizes the report’s methods, findings,and recommendations, and then reviews the comments and criticisms that appeared soon after the Report was issued. Changes in the CPI are summarized and assessed, as is recent research on related issues. The paper sharply distinguishes two questions. First, with what we know
now, what should the Commission have concluded about CPI bias in 1995-96?

Second, what is the bias now after the many improvements introduced into the CPI since the Commission’s Report?

About the first question, my own recent research on apparel and rental housing indicates a substantial downward bias in the CPI over much of the twentieth century,diminishing in size after 1985. Incorporating these findings into the Boskin matrix would reduce its 0.6 percent annual upward bias due to quality change and new products to a smaller
0.4 percent bias. However, this is more than offset by the stunning discrepancy over 2000-06 in the chain-weighted C-CPI-U compared to the traditional CPI-U, indicating that the Commission greatly understated the magnitude of upper-level substitution bias. This retrospective evaluation suggests that the Boskin bias estimate for 1995-96 should have been 1.2 to 1.3 percent, not 1.1 percent.

Current upward bias in the CPI is estimated to have declined from the revised 1.2-1.3 percent in the Boskin era to about 0.8 percent today. Yet the Boskin report, like most
contemporary studies of quality change, failed to place sufficient value on the value of new products and on increased longevity. Allowing for these, today’s bias is at least 1.0 percent per year or perhaps even higher.

Keywords: inflation, price measurement, substitution bias, quality change, new products, medical care
JEL Codes: I1, I11

Robert J. Gordon
Department of Economics, Northwestern University
Evanston IL 60208-2600
(847)491-3616
rjg@northwestern.edu
http://faculty-web.at.northwestern.edu/economics/gordon

[Uncle Miltie]

Can anyone summarize the above to any more than:

“We disagree”?

[Uncle Miltie]

I may have missed your post in which you parry the BLS report at the top. Please direct me to it.

Also, please see the Northwestern Professor’s post in which he believes CPI remains overstated, and prove him wrong.

I’m open to the arguments, I just need to see them plainly address the rebuttals.

[CharlesWayneCT]

A very interesting read. I will quickly though disagree with the report on one critical matter:::

There is no universe in which Yogurt is a reasonable substitution for Chocolate Ice Cream.

[algernonpj]

Uncle Miltie,

I wanted to get this out to you now; I just have time for a few comments on the fly; busy weekend

The article ‘Addressing misconceptions about the Consumer Price Index’ by John S. Greenlees and Robert B. McClelland lists what it labels as common misperceptions about the CPI and does a poor job of refuting them.

“that Social Security payments are indexed to a CPI that does not include food or energy”:
Neither myself nor Williams has claimed that Social Security payments are indexed by a CPI that excludes food and energy.

“that the 1983 change in the way the BLS measures homeownership costs lowered the rate of increase of the CPI; “
The fact that the public often mistakenly believes this is understandable since both the media and the Fed point to core inflation to demonstrate how the effectiveness of monetary policy in keeping inflation low.

Recently the president of the NY Fed, William Dudley gave a speech cheer leading for how low inflation is, in which he stated “The Fed looks at core inflation, which strips out volatile food and energy costs, to get a better sense of where inflation may actually be heading.”. Dudley then gave the example of how "Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful,"

“that the 1983 change in the way the BLS measures homeownership costs lowered the rate of increase of the CPI;”
As to the rent, see Post # 11 here. I don’t have time to re-research this item now. IIRC under Reagan ‘rent equivalence’ was introduced to weight the actual costs of home ownership and purchase using ‘rent equivalence’.

“that the BLS lowers the CPI to reflect consumers’ substitutions of hamburger for steak;”:
This statement is the next best thing to a lie. It is downright misleading. The Boskin report, cited frequently by the BLS, actually uses the substitution of chicken for steak as one of its justifications for hedonics adjustments, quality adjustments, substitution adjustments using geometric weights. While the Boskin Report did not use the actual words hamburger for steak, the concept is the same! Reminds me of the renaming of man made global warming to climate change.

Here are some examples of the substitution effect, hedonics, and quality change in action:

A walk through of the adjustment to price of a new TV is found here here.

A 27” CRT TV which is no longer available is replaced by its nearest equivalent a 42” flat screen. There is a –7.1% quality adjustment to the price used in calculating the CPI.

"A quality adjustment has been made to gasoline prices used in the January CPI to account for the effects of the mandated introduction of reformulated gasoline in selected areas of the United States. The gasoline index rose 0.4 percent in January, following seasonal adjustment. Without the quality adjustment, it is estimated that this index would have increased 1.1 percent.."

There is a -.7% quality/hedonic adjustment of federally mandated changes to the price used in calculating the CPI

I recently had to replace an old refrigerator. I bought the closet equivalent which uses the new and more expensive federally mandated coolant that replaced Freon. There will be an -n% quality/hedonic adjustment of federally mandated changes to the price used in calculating the CPI.

Now in the real world, the consumer pays the full price of the flat screen tv, not the full price –7.1%. The consumer pays the full price for gasoline, not the full price of gasoline -.7%. I paid the full price of the new refrigerator, not the full price of the refrigerator –n%. When a consumer who normally buys steak, substitutes hamburger or chicken or Spam because the cost of steak has risen to the point where he can no longer afford it, inflation has lowered his standard of living.

Changes in taste, quality, and the substitution of lower priced goods for higher priced ones were once accommodated by periodic surveys and arithmetic weighting.

So it all boils down to a simple concept. Does the CPI reflect inflation or the Consumer Price Index as accurately as it did before the introduction of the soft metrics of substitution, hedonics, quality adjustment using geometric weighting. Reality based common sense says that it does not.

Now a word about the BLS and definitions.
Over time the BLS has changed the definition of the CPI from being a Consumer Price Index to being a ‘Cost of Living Index’.

Per the BLS, a Consumer Price Index measures a price change for a constant market basket of goods and services from one period to the next within the same city (or in the Nation, whereas a Cost of Living Index measures differences in the price of goods and services, and allows for substitutions to other items as prices change.

In addition the BLS has its own special definition of a Cost-of-Living-Index’, to wit it accommodates for the substitution effect described in the Boskin Report. Perhaps a better word is Cost-of-Existing Index. Talk about what is the meaning of is!

IMO and experience Shadow Stats charts more closely represent inflation. Considering how the FDA and EPA, two government agencies that in theory are run on scientific considerations have been corrupted by political considerations, why would the BLS be exempt? The BLS is a unit of the Department of Labor, which is a cabinet department whose head serves at the pleasure of the current administration. It is staffed with the same ilk that staffs the EPS and FDA- career academics with no real life reference point.

Some of the relevant links are found here and here.

Re post #http://www.freerepublic.com/focus/news/2703730/posts?page=31#31 , it is a modification of post #35 which is in response to this post.

Reality Calls. Will check back.

[algernonpj]

Thanks for the into. Well what do you know, what goes around does sometimes actually come around! He’s been skirting the edge for a long time.

[algernonpj]

...Reading about the Boskin Commission can make your brain fry and kill your soul, so be warned...

Trying to track US CPI brings insight for archaelogists trying to understand why Mesopotamians abandoned Cuneiform A record keeping.

Two great comments.

[CutePuppy]

Non-sequential thoughts on what does and doesn't make sense in the BLS CPI index:

It makes sense to exclude extremely volatile items from Core CPI, as it would make it difficult to evaluate from month to month or Y-o-Y, whether the spike or fall in market prices of energy and food staples are temporary (due to crop drought or weather anomalies, geological conditions, geopolitical upheaval(s), industrial accident(s) etc.) or more permanent developments. The good thing is, that if energy cost is more "permanent" (let's say, stays at a "new normal" level for 3-6 months. it tends to seep into and be reflected in the prices of consumer products (including food) due to costs associated with production and delivery of such products...

In other words, we'll see "permanent" cost increase/decrease of generally volatile products reflected in Core CPI anyway, with some lag, after it's incorporated in the cost of the products or service, but the Core line will be smoothed over period of time, rather than sharp spike up or down or non-Core index.

Another reason it makes sense to exclude food prices from non-Core CPI is that generally they does not comprise a large percentage of household expenditures (generally, the lower the household income the more it's affected by food prices). Food and energy prices are also varied widely depending on where household is located, rural or urban areas, cities and states. However, along with gasoline (part of energy cost), it's one of the most visible and comparable costs for the U.S. households, so it generates the most heated and emotional complaints about "inflation". Food is also the most likely subject to "hedonic" substitution or even [temporary?] exclusion from the people's diet (BTW, dog/cat/pets food maybe a notable exception from this but I believe that it doesn't quite affect the CPI so it's irrelevant for this discussion).

It makes sense to use and periodically adjust "hedonic" regression / substitution, or we would still be working with the cost of buggy whips and costs of cleaning up horse manure from the streets. Yes, it's open to some political biases and influences, but likely less than generally suspected.

Buying generic label cereals or canned food, using bicycle, motorcycle, more efficient car or carpool, for example, are forms of hedonic substitution that are commonly practiced, but might be difficult to reflect in index without detailed data measuring these on a regular basis. Also, technology is a relatively constant disinflationary force, so giving it a higher weighting in the index would tend to pull index down.

Depending on the mix of the items in the BLS basket relative to what we tend to purchase (as a percentage of our income or costs) we will all see the different "realities" of COL... in other words, to people it's subjective and personal, while BLS is attempting to reflect the "average" CPI.

Also, we should not forget that recent droughts in the U.S., Australia, Africa, lingering long-term fiscal and monetary problems in certain EU countries (PIIGS) and dangerous political instability in Africa and Middle East, along with misguided politically motivated subsidies and "green" / environmental policies (not just in the U.S) have sent prices of food staples and energy (particularly oil) sharply higher in recent months. Add to that the huge inflation in China and India (and less relevant, in Brazil) which for years have been exporting deflation but are now starting to export [relative] inflation, and that the U.S. is just now coming out from the Great Recession and sharp disinflation (from about H2 of 2007 through 2010), and some inflation in the recovery ought to be expected.

BLS is doing a pretty good job of collecting data, and decent job of comprising and analyzing index, and separating Core from non-Core components. That said, no system is perfect and would satisfy everyone. Given that the data points are detailed in BLS reports, anyone can "personalize" their own "basket" of items and index it based on the weighting they want to attribute to each item, as they most affect the author of the index.

As long as we don't try to compare the today's cost of the "basket of apples" with the last year's cost of the "basket of oranges," we should do fine in proving just about anything we want, from our own view on price inflation/deflation.

There are credible attempts to create other indices that measure "price inflation" or consumer cost. Here is the most interesting recent one - MIT's BPP (Billion Prices Project) at http://bpp.mit.edu/daily-price-indexes/?country=USA

These indexes are designed to provide real-time information on major inflation trends, not to forecast official inflation announcements. We are constantly adding new categories of goods, but we do not cover 100% of CPI goods and services. The price of services, in particular, are not easy to find online and therefore are not included in our statistics.

It's a set of interactive charts of Daily Online Price Index, Annual Inflation and Monthly Inflation. Keep in mind the differences from BLS CPI, but it's exactly why it may attract some people who are suspicious about BLS CPI - it only uses online price data, data is NOT "seasonally" adjusted, BPP includes the food prices but doesn't include energy prices.

Both CPI and BPP were up significantly in the last couple of months, but not much on Y-o-Y basis.

Some references that may be of interest:

From Why inflation hurts more than it did 30 years ago | Inflation hurts more than it did 30 years ago for Americans stuck with flat income - AP via Breitbart, 2011 March 18

Inflation spooked the nation in the early 1980s. It surged and kept rising until it topped 13 percent. These days, inflation is much lower. Yet to many Americans, it feels worse now. And for a good reason: Their income has been even flatter than inflation.

Back in the '80's, the money people made typically more than made up for high inflation. In 1981, banks would pay nearly 16 percent on a six-month CD. And workers typically got pay raises to match their higher living costs. No more.

Over the 12 months that ended in February, consumer prices increased just 2.1 percent. Yet wages for many people have risen even less - if they're not actually frozen.

Social Security recipients have gone two straight years with no increase in benefits. Money market rates? You need a magnifying glass to find them. That's why even moderate inflation hurts more now. And it's why if food and gas prices lift inflation even slightly above current rates, consumer spending could weaken and slow the economy. ..... < snip >

From Inflation Actually Near 10% Using Older Measure | Inflation Using Volcker-Era Methodology Nearing 10% - CNBC, by John Malloy, 2011 April 12

< snip > ..... Inflation, using the reporting methodologies in place before 1980, hit an annual rate of 9.6 percent in February, according to the Shadow Government Statistics newsletter.

Since 1980, the Bureau of Labor Statistics has changed the way it calculates the CPI in order to account for the substitution of products, improvements in quality (i.e. iPad 2 costing the same as original iPad) and other things. Backing out more methods implemented in 1990 by the BLS still puts inflation at a 5.5 percent rate and getting worse, according to the calculations by the newsletter's web site, Shadowstats.com.

"Near-term circumstances generally have continued to deteriorate," said John Williams, creator of the site, in a new note out Tuesday. "Though not yet commonly recognized, there is both an intensifying double-dip recession and a rapidly escalating inflation problem. Until such time as financial-market expectations catch up with underlying reality, reporting generally will continue to show higher-than-expected inflation and weaker-than-expected economic results in the month and months ahead." The pay-site and newsletter by Williams, an economic consultant for the last 30 years to companies, has gained a cult following among bloggers hungry to criticize Bernanke these days. ..... < snip >

..... To be sure, the BLS argues that the changes it has made over the last three decades more accurately reflect a true change in the cost of living. For example, in response to its hedonic adjustments, the BLS web site states, "to measure price change accurately, the CPI must be able to distinguish the portion of price change due to this quality change." ..... < snip >

[JerseyHighlander]

A follow up:
Here is a graph of housing priced in oz of gold, going up to 2009, as you know gold has gone up significantly since then, so housing priced in gold is now at a historic low.

http://www.scribd.com/full/53173995?access_key=key-1ho959hci98ji6x04lsj

[algernonpj]

Here’s another approach to explaining why hedonics / quality adjustments and substitution / chained dollars put into using geometric weighting have corrupted the CPI.

According to the BLS, the CPI is the most commonly used indicator of inflation, i.e. the average change over time in the cost of goods and services.

As such it influences interest rates, the stock market, and a host of salary and pension negotiations each year. It is used by the Federal Reserve to justify its money printing policies, to set the interest rate on inflation-adjusted bonds known as TIPS, and by the federal government to calculate cost-of-living adjustments (COLA) for the entitlement programs (e.g., Social Security). The more inflation is understated, the higher the inflation-adjusted rate of GDP growth that gets reported. In addition, the CPI influences interest rates, the stock market, and a host of salary and pension negotiations each year

All these uses require an index that measures the consumer cost of a set standard of living, i.e. an apples to apples comparison.

Concepts such as hedonics, quality adjustment, substitution effect, chained dollars, and intervention analysis are all soft metrics that introduce changes to actual consumer’s cost of purchasing a fixed basket of goods. The specious changes that reflect subjective value judgments from a government agency staffed with people who have more education than common sense and real life experience. When the CPI is calculated, these value judgments determine what quality changes are worth to you, when you will substitute one item for another, which items you will substitute for one another, and when a price goes up ‘too much’.

How for instance is the mandated replacement of incandescent light bulbs with CFL’s valued? Which does life experience tell you happens: a positive quality change is determined because of the PC impact on ‘climate change’ and the CPI is adjusted downward, or a negative quality adjustment is determined because of mercury added to land fills, increased electric usage for those places where lights are routinely only turned on briefly, increased headaches and even seizures in those who are sensitive to the flicker inherent in CFL’s and the CPI is adjusted upward?

How do the mandated low flow toilets affect the CPI? Is the CPI adjusted downward because each flush uses less water and ‘helps save the environment’? Is the CPI adjusted upward because it often requires more than one flush to get the job done, or because when added to older plumbing the new toilet is prone to problems overflowing?

How about the substitution of PE for PPA, an OTC decongestant the FDA removed from the market for political not scientific reasons? Is the CPI adjusted downward because PE is politically correct and therefore represents a quality improvement or is it adjusted upward because PE is an inferior medication when compared to PPA?

Whether a quality change is positive, negative, or neutral is up to the individual consumer. When and what substitutions occur as a result of price change again is up to the consumer, based upon a host variable unique to each person.

[algernonpj]

I’ve re-located a few of the articles to which I have lost links:

Here’s an article by Bill Williams of Pimco about the CPI undercounting inflation:
“I’ll tell you another area where we’ve been foolin’ ourselves and that’s the belief that inflation is under control”

Another article citing Bill Gross of Pimco and Andrew Harless, vice president of econometric analysis at Atlantic Asset Management and others taking issue with hedonics.

The Three Stooges of Inflation from Mises.

[Uncle Miltie]

What did you think of Cutepuppy’s post at #31?

[algernonpj]

What did you think of Cutepuppy’s post at #31?

Regarding core inflation. I don’t know enough to make a lot of comments. I do however question its appropriateness as the inflation number most frequently cited in the media and as the only inflation number used by the Fed in evaluating monetary policy. After all we need to eat and we need energy. I also have a vague memory reading that focusing on core inflation leads to monetary policies that debase the dollar, but have to look up that information could be that this is something true more recently, but not in the past 20 -30 years.

The only chart I could quickly find comparing headline to core inflation, showed both consistently trending upward. This questions the validity of rationale that headline inflation demonstrated wild swings because it included food and energy.



Focusing on the rationale for using hedonics, quality adjustments, substitution effect, and geometric weighting only draws one’s attention away form the fact that the CPI has moved from evaluating inflation in terms of a certain standard of living to evaluating inflation in terms of a declining standard living. Since the uses of the CPI (economic indicator, deflator of other economic indicator, a standard to evaluate returns on investment, a standard to evaluate COLA adjustments to wages and other payments) require an apples to apples comparison they have no place in calculating the CPI, other than to artificially depress the CPI. These tools are constantly being used over more and more categories. By now they may have extended to all of them.

I believe it was Bill Gross of Pimco who said that the Owners Rent Equivalent instituted in 1983 suppressed the CPI ~1%. I remember reading that that number increased to about 3-4% when the housing market heated up.

While flat (or declining or no) income makes inflation seem worse than 30 years ago, I believe that there are other factors involved. All the ‘interesting’ things occurring on Wall Street and in the Financial industry have lowered the value and return of savings and retirement funds. Housing values have plunged. Inflation over the last 10+ years is no longer hidden by ready access to cheap credit, and cheap goods made in third world countries by workers getting 25¢ per hour.

[Uncle Miltie]

You and Cutepuppy look at the same information with a reasonable understanding and come to differing conclusions. I can live with that. I understand the difference in perspective.

Now a slightly different question: Considering that a housing price bottom is still nowhere in sight, doesn’t that mean that actual Wealth (Net Worth, excluding recent stock gains) is still decreasing rapidly? Isn’t a continuous reduction in Wealth the equivalent of negative earnings, offsetting stagnant actual wages? Therefore, with relatively modest actual inflation (whether Headline or Core) and declining earnings (by my definition above), don’t we have an effective inflation rate of Prices / Earnings that is substantially higher than either Core or Headline CPI report?

I think the negative wealth effect of housing is killing families’ ability and willingness to spend their fewer and fewer asset / earnings dollars on the somewhat more expensive stuff of life.

That would perfectly explain the difference between CPI (modest increases) and Americans’ perceptions (we’re getting poorer and hosed.)

I think the bottomless housing market price indicts the “Owners Equivalent Rent” component of the CPI as optimistic. If Owners Equivalent Rent takes into account CURRENT market prices of houses which have declined, but the average American lives in a house and pays a mortgage based on a higher acquiring price of 5 years ago, then Owners Equivalent Rent understates what actually happens to peoples’ bank accounts. Mortgage payments that are hard to walk away from remain high, while the Owners Equivalent Rent component of the CPI declines. That’s just fakery.

The adjustable component of Owners Equivalent Rent only comes to particular individuals who default on their mortgages and walk away. In that way, only the morally suspect are rewarded with the actual reduction in Owners Equivalent Rent. Upstanding citizens who honor their commitments are killed by stagnant wages, reduced house asset value, and actual CPI. I don’t see how those folks aren’t completely hosed by current circumstance, in a way that effectively creates a massive CPI for them individually.

Your thoughts, gentlemen / ladies?

[algernonpj]

Agree totally that the owner's rent equivalent is just fakery, in fact blatant fakery. In fact IIRC that's why other countries decided not to use OER in computing their CPI. Those who purchased homes over the past 10 - 15 years are really poorly served in the calculation of the CPI.

Also agree that the middle class has lost a massive amount of wealth over approximately the last 10+ years. I just have not met anyone who has not seen the value of their home tank, the value of all or most of their saving tank, and who, if they still have a job, have not had a raise in several years.

I do not believe that the current nor recent nor near recent increases in cost of living are/have been modest. IMHO they are being understated and have been for many years.

In my, and associates experience(many of us have small businesses), inflation has been creeping in at least since the mid 1990's. Until ~ 2000, even if raises did not exactly keep up with inflation, there were raises. Salaries and the job market were declining in the early 2000's and tanked with 9-11. After 9-11 salaries and job market never really recovered.

This just reminds me of another stressor on income and wealth: guest workers,off shoring, and the cost of anchor babies and brand new immigrants and their extended families plus ~ 40 million illegal aliens (both those who tromp over the borders and visa overstays), are plopped on SSI and sundry freebies.

In addition taxes have increased, lowering take home pay.

When all of the above hit you, probably depends upon the field you are in, and where you live.

We are truly living the curse of 'interesting times'.

[algernonpj]

Forgot:
While you and I may not have fallen for all the ‘financial experts’ who used to taut ‘debt is good’, ‘your home will keep increasing in value’, ‘your salary will keep going up’, I have been surprised at how many people believed this. For these people ready access to cheap credit help hide the real impact of inflation on their lives.

[CutePuppy]

Actually, the article algernonpj linked to on the use of hedonics (An inflation debate brews over intangibles at the mall - WSJ, by Timothy Aeppel, 2005 May 09) explains pretty well why asset substitution and hedonics are not only legitimate, but necessary methods of calculating price inflation lest it is overstated. Also, the controversy about hedonics was really limited to a very small percentage of CPI component which BLS decided to stop using.

Article also explains why different income groups will see and feel and, therefore, react to their personal or visible (price of food in grocery store, gas prices posted in large numbers at gas stations along the route) price inflation, and why there were suggestions of breaking index down into several different CPI rates, according to "baskets" by income, instead of BLS issuing the single "average" CPI.

That's also the conclusion from the article I linked before:

These days, inflation is much lower. Yet to many Americans, it feels worse now. And for a good reason: Their income has been even flatter than inflation.
Back in the '80's, the money people made typically more than made up for high inflation. In 1981, banks would pay nearly 16 percent on a six-month CD. And workers typically got pay raises to match their higher living costs. No more.

Much more relevant adjustment that has been made in the 1990s but doesn't get talked much about (maybe because it seriously overstated previous CPI) was change from arithmetic / compounded rates to geometric rates. (See Inflation, Hedonics, and How Silicon Valley May Have Wrecked Our Monetary Policy - Adam Nash, 2008 February 27)

The Bloomberg's Chart #3 that shows the difference between Core CPI and non-Core CPI is interesting in a couple of respects:
1. What sense would it make for BLS to understate Core CPI while at the same time showing "normal" non-Core CPI (which includes food and energy) - wouldn't they think that the difference would explode exponentially over time and lose their relative correlation over long period of time?

2. (Partially, an answer to 1.) The Bloomberg chart is only from the small period of early 2005 (during sharp housing and energy inflation) to the early 2008, just before the period of sharp housing and energy deflation. At that period, it's quite possible that non-Core CPI would dive faster and harder than Core CPI.

Here is a Bloomberg's chart for a Euro-Zone price inflation over period from 2005 to March of 2011, where you can see the "Big Swoon" from 2008 to 2010 (chart is "normalized" for annual rates, so it's easier to see):

Re OER (Owner Equivalent Rent):

It pays to take note that housing comprises about 30% of CPI, and that the disparity between the price of "similar" house is huge and varies greatly depending on state, city and other geography - "Location, Location and Location". Good luck measuring "average" house price, and the "equivalent" cost to the people who do not own one. It seems reasonable to "normalize" owners and renters with a common metric for the purposes of "average" index. OER is basically a first derivative of house ownership.

And while the housing prices were bubbling up dramatically in some geosectors of the country, the rents didn't (sometimes due to rent controls, sometimes due to market forces). That means that the usual metrics of the house pricing (Price to numbers of years of gross/net annual rent income, or PS/PE equivalent for equities) were getting seriously out of whack, i.e. people were paying more and more for the houses with the essentially same rent / OER.

Following articles explain the relationship between prices and rent or PS/PE, in different locales:
Housing Trends | America's Most Overpriced Real Estate Markets - Forbes, by Matt Woolsey, 2007 May 04
Housing Trends | Most Affordable U.S. Real Estate Markets - Forbes, by Matt Woolsey, 2007 August 02
Housing Trends | Least Affordable U.S. Real Estate Markets - Forbes, by Matt Woolsey, 2007 August 23

While BLS calculates the housing and OER in terms of "cost," the owners of property usually consider it "wealth." Of course, the ownership "wealth effect" obscured that fact, and the "flippers" didn't care about PS/PE ratios in the first place, during the bubble. Now the "wealth effect" is negative, but the rents generally are not coming down in price nearly as fast as the price of the house, so OER can smooth the inflation/deflation line (similarly to Core CPI) relative to more volatile (at least in recent years) real estate prices.

Basically, for the owners, the "wealth effect" obscured the relationship to rent prices (and their "natural" relationship to the price of the house) just as now the negative "wealth effect" obscures the fact that the rent prices have changed mostly with the "rate of inflation," or relatively little over last 5-8 years, while the ratios of property prices to rent had wide swings.

It makes sense that the people who think that CPI is understating the visible food and energy price inflation, would think that BLS also understates the decline in housing prices in some geographical areas that are visible signs of burst bubble (e.g., AZ, CA, FL, NV, NY) BLS is trying to measure the change in cost of "rent equivalent" or rent, not the change in wealth.

What we feel as overall price / cost increases or decreases is very subjective depending on our "reality" and our own "basket" of goods and services, and its relationship to our income and spending habits (our "weighting") - it very seldom resembles the "average" (which in itself is difficult enough to measure).