Is the US government wildly understating the inflation rate? No, it isn’t

It’s hard to find much inflation in the US economy right now. As measured by the Labor Department’s consumer price index, prices increased by just 1.7% in 2012. The core CPI, which excludes food and energy prices, rose by 1.9%.

Nor can much inflation be found in an alternate measure, the Commerce Department’s personal consumption expenditures prices index. It rose 1.45% for the twelve months ending last September. Excluding food and energy, it rose 1.58%. Federal Reserve Chairman Ben Bernanke prefers the PCE price index because he believes it better reflects changes in consumer purchasing habits.

But some skeptics say those government-generated statistics are nonsense. The numbers are skewed — perhaps intentionally — to show inflation much lower than what it really is. Instead of 1% to 2% annual inflation, prices have actually been rising at 10% a year, maybe even faster.

Now, extraordinary claims should require extraordinary evidence. So the burden is on the inflation hawks here. As it is, the Labor Department has specifically and thoroughly rebutted many of the criticisms of the CPI, including charges that when the price of steak rises, the Bureau of Labor Statistics swaps it out for cheaper hamburger. Or that Social Security payments are indexed to a CPI measure that doesn’t include food or energy.

In particular, critics question how the BLS currently a) assumes consumers will purchase the cheaper of two types of products, and b) takes into account, for instance, that a $1,000 computer today is a whole lot more powerful than one 15 years ago. Those are just two of the modifications the BLS has made over the years in how it measures inflation.

But what if BLS still calculated inflation the way it used to back in the 1970s? The agency studied that exact question in 1999, and found the new approach gives only a modestly lower inflation reading:

Over the 21-year period of the study (December 1977 to December 1998), the CPI-U-RS increased 141.2 percent, compared with 163.9 percent for the CPI-U. The figures represent an average annual increase of 4.28 percent for the CPI-U-RS and 4.73 percent for the CPI-U; the average annualized difference between the two measures is thus 0.45 percent.

In fact, there’s considerable academic literature suggesting that Washington continues to overstate inflation rather than understate it, such as this paper by Robert Gordon of Northwestern University:

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. … 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.

One final reality check — especially clarifying if you believe Washington is intentionally cooking the books — is MIT’s Billion Prices Project, which uses an algorithm to track prices online, including most of the products and prices found in the CPI. It has inflation running at less than 2% over the past year:

Now, inflation might well be far higher in the future than it is today. And of course, the inflation rate experienced by any one individual may differ, perhaps considerably, from a broad national index. But inflation overall, much less hyperinflation, isn’t a big problem right now.

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