May 28, 2008

An incendiary mix! Inflation, CPI and the U.S. Federal

Reserve
by Ron Robins, MBA

From my blog: Enlightened Economics

The U.S. Consumer Price Index (CPI) does NOT measure inflation
It is stunning how confusion reigns on the subject of inflation. Simply put: the
Consumer Price Index (CPI) does not measure inflation. It tries, imperfectly, to
measure the cost-of-living. Inflation and cost-of-living are not the same thing!
As elite economists from Nobel Laureate Milton Friedman to the Bank of
England’s Mervyn King comment, inflation is a monetary phenomenon. It is
evidenced by excessive expansion of the money supply which exceeds economic
growth. Therefore, the basis for higher prices in an economy is ‘too much’
money.

One measure of current U.S. broad money supply shows it growing at an annual
rate of over 16%! However, there is considerable debate as to what money
supply measure best links it with inflation. (I suspect that for developed
countries, we might see credit expansion playing a much more important role in
understanding the inflationary process than is currently appreciated. But that is
for another post to research.)

Most people believe the CPI measures a fixed basket of goods and services over
time. That is again, incorrect. It used to be the case, but not anymore. The
current CPI basket of goods and services is constantly changing according to
what bureaucrats think people are buying, and by numerous statistical
alterations they deem ‘appropriate.’

How the U.S. Bureau of Labor Statistics (BLS) modifies the CPI to show
tame inflation
The kind of huge modifications the U.S. CPI is subjected to include the
following:

• Substitution of products. Should prices rise, it is inferred people will substitute

with something less expensive.
• ‘Hedonic’ adjustments. If computers’ performance doubles, the relevant index
component is halved.
• Weighting changes of index components. If an item becomes suddenly
expensive, it may receive a smaller index weighting.
• Chain-weighting. Applies to some ‘versions’ of the CPI. This smoothes-out
sudden price changes over many months and means indexes using this are
always ‘behind-the-curve.’
• Intervention analysis/seasonal adjustments. Bureaucrats adjust index
components according to historical seasonal variations, whether warranted in
the current year or not. (See: The Government’s Statistical Whopper of the
Year, by Robert P. Murphy.)

Hence, the BLS is able to manipulate the CPI to whatever doctrine holds sway at
the time. Prior to about 1980, there actually was a fixed basket of goods and
services that comprised the CPI. It did a much better job of measuring inflation
caused by monetary expansion. But politicians and some academics did not like
this as they said it overstated the actual cost-of-living. For instance, they
figured that if beef became expensive, people might buy chicken, and so on,
thereby reducing living costs, and thus effectively lowering the index.

Of course, these types of changes also inferred lower living standards. But no
politician, or a bureaucracy headed by a political appointee such as the BLS,
would want to say that!

CPI inflation over the past year: using 1980’s configuration, nearly
12%; using current methodology, 3.9%!
So around 1980 the CPI began to be massively modified and thus began the
trek of divorcing it from monetary inflation. The difference in numbers between
the 1980s CPI inflation measure and today’s cost-of-living CPI is extraordinary!
John Williams at http://www.shadowstats.com/alternate_data shows that for
April 2008, the CPI using 1980s methodology shows inflation over the past year
of close to 12%; using CPI (CPI-U) as constructed today it is just 3.9%!

There is no doubt that the ideal of trying to get a consumer price index that
reflects the reality of consumer buying behaviour is a good one. But to rely on
the current CPI as a means of determining U.S. inflationary pressures so as to
modify its monetary policy, is, at first glance, illogical. However, there is
something else going-on here.

The Federal Reserve uses current CPI to fool the world in supporting
U.S. economy and artificially high bond, stock prices
The U.S. Federal Reserve often cites the CPI as being very influential in shaping
its monetary policy. From the foregoing this seems to be a very strange policy.
When viewed through a political lens and the need to maintain confidence in the
U.S. economy though, it makes sense to try to fool the world at large that
inflationary pressures are minimal within its economy.

The U.S. economic problems are so big that if the Federal Reserve and other
government agencies came clean on the true rate of inflation, we would see:

• U.S. economic growth would be shown to have been negative for several
years now (real GDP growth rate = nominal growth less inflation)
• Bond yields would soar
• Stock market could rise in highly inflationary environment or crash should
deflation take-over
• U.S. government deficit rocket higher
• Severe economic downtown. Perhaps a depression

As consciousness rises investors everywhere will begin to understand the

distinction between U.S. monetary based inflation that is in the double digits,
and a highly stylized, theoretical, consumer price index that minimizes the
monetary inflationary threat. Prices of everything will then be re-set
accordingly.

There is huge danger ahead should the U.S. monetary and credit expansion
continue unabated. The excess funds will find their way into more asset classes
and lead to further big asset bubbles – and busts. Commodities anyone! Oh,
what an incendiary mix!
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© Ron Robins, 2008. Permissions: Provided full credit, which includes title, my name, and link
to this post is given, anyone may print or re-produce this article in part, or in full, to any
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