CPI (Consumer Price Index) Based Upon Statistical Flimflam

This is how the government cooks the economic statistics:

Jubak's Journal12/5/2008

Fake inflation numbers masked crisis

Distortions in the way inflation is calculated contributed to today's financial mess and the 2000-02 tech crash. Unless the problem is fixed, you can count on another crisis ahead.

By Jim Jubak

How do we make sure we don't replay the current financial crisis five years from now?

So far, all the plans, revised plans and re-revised plans that have come out of Washington have focused on saving the banks, Wall Street, the financial system, the U.S. economy and the global economy from a devastating meltdown. That's certainly important.

But unless we address the root causes of this crisis, we're going to find ourselves back in trouble way sooner than we'd like. It took us only five years to go from the bottom of the 2000-02 technology crash and bear market to the top of the real-estate and financial-leverage boom market in 2007. Without essential reforms, I'm afraid we'll be looking at a crisis much like the current one in another five years or so.

What reforms are essential? I'd start with fixing the way we measure inflation. The official inflation number is so misleading that it played a huge role in creating the tech stock bubble that broke in March 2000 and in the leverage bubble that broke in 2007.

3 major shifts in figuring inflation

Most criticism of the official inflation number, the Consumer Price Index, or CPI, has focused on the statistical flimflam used by the Bureau of Labor Statistics to calculate how fast prices are going up.

Chief among these is a technique called hedonics. Starting in the 1990s, some economists and government statisticians began arguing that a $100 increase in the price of, say, a car wasn't really a $100 price increase if the power, safety features or general usefulness of the car improved substantially. If the subjective value of the car went up by $100, then, despite the increase in what you paid, according to the government, the price didn't go up at all.

The objection to this kind of adjustment is that it introduces a huge amount of subjectivity into the process of calculating inflation. Determining the increased usefulness of a product or service requires a subjective judgment about the value of this or that feature. What is the extra horsepower of a car worth to a user? How about extra safety features? And to which user? And if the cost of a car went up by $100 even if it came with more and better features, wasn't the price still in reality $100 higher?

Hedonic quality adjustments weren't the only statistical adjustments that the government made to the inflation numbers. Starting in 1983, the government also started to measure changes in the cost of housing by looking not at the cost of a house but at what an owner would get if he or she rented out that house. Since in a housing boom the price of houses rises about three times as fast as rents do, this change understated the rate of inflation.

In the 1990s, the government also started to include substitution pricing in its inflation measure. In this adjustment, government statisticians assumed that if the price of something went up, people would use less and would substitute a less costly product or service. So when steak went up in price, consumers might buy more pork or chicken. Figuring out what substitution a consumer would make again added to the subjectivity of the inflation numbers. Including substitution destroyed the whole point of the exercise because it turned the government's shopping basket from an inflation measure to a set of lifestyle choices.

How big an impact?

It's hard to figure out exactly how much these three changes have subtracted from the rate of inflation. The St. Louis Federal Reserve Bank calculated that the use of rental equivalents to estimate housing cost increases might have subtracted somewhere around half a percentage point from the official CPI.

Bond guru Bill Gross figures the changes were worth a full percentage point off the official inflation number. Other estimates put the effect of the change at anywhere from 5 to 8 percentage points.

Adding even 1 percentage point to the official rate would have put the real rate well above the 2% to 3% target as early as October 2002, when the official rate was 2.03%. At that point, the Federal Reserve, relying on the official rate of inflation, still had seven more months of cutting interest rates ahead of it and then 12 months with Fed-controlled interest rates at just 1%.

The distortion in the inflation rate compounded a huge policy mistake. In retrospect, keeping interest rates at just 1% for so long allowed the mortgage bubble to develop. Seven months spent cutting interest rates when the unadjusted inflation number showed that the central bank should have been raising rates just made that mistake even worse by giving cheap money a longer chance to build up momentum in lifting housing prices.

Lessons from the bubbles

But even reversing the adjustments that have distorted the official inflation figures won't fix the basic problem with the way we calculate inflation. Think of this: If the price of a can of soup goes up 10 cents, that's inflation, but if the price of a stock soars by 100%, that doesn't count as inflation at all.

That might have made sense once upon a time, when increases in the money supply in one country didn't have a chance to move around the world to create global asset booms or when traders in New York couldn't borrow yen in Tokyo to bid up the prices of stocks in New York and London. But it sure doesn't make any sense in the current global economy, when floods of cash can move directly into asset markets, leaving the prices of goods in the real economy relatively unaffected.

Look at what happened in 1999 and 2007 as bubbles in the asset markets expanded toward bursting. In August 1999, the Federal Reserve did indeed increase interest rates to 5.25% from 5%, but that was only a return to the 5.25% rates of September 1998. Interest rates had been higher in March 1997, but then the Fed spent the next year and a half lowering rates until they hit 4.75% in November 1998. There wasn't any reason to raise rates in 1998 because inflation was a very modest 1.6% -- officially -- that November.

Of course, stock prices were showing a rather amazing rate of inflation of their own. The Nasdaq Composite Index ($COMPX) climbed 39% in 1998 and 86% in 1999. Alan Greenspan's Federal Reserve kept its hands in its pockets as asset values soared, however. The Greenspan Fed's policy was to let asset bubbles follow their own course rather than intervene.

The central bank could have raised interest rates to slow the economy as a whole -- and the stock market along with it -- or it could have used its power to set margin requirements to reduce traders' ability to borrow money to buy shares without affecting the economy as a whole. But instead, the Federal Reserve chose to do nothing. Half of the Fed's mandate is to control inflation, but since the bank doesn't include asset prices in its view of inflation, it could reasonably decide to do nothing.

Same problem, same lack of solution in the run-up to the mortgage bubble that broke in 2007. The Federal Reserve knew housing prices were rising in a speculative fever -- Greenspan famously dismissed the bubble as "froth" -- but with official inflation so low, the Fed didn't need to move aggressively to reduce the rate of inflation in asset prices. Again, the Fed could have raised interest rates to slow the general economy or used specific powers -- in this case its power over bank reserve requirements and lending standards -- to reduce the amount of mortgage money available to homebuyers without slowing the economy as a whole.

Another look at the numbers

A few economists have begun to develop systems that would include asset prices in a measure of inflation. The job is hard, but from the papers I've read, not impossible.

The miscalculating of inflation contributed to our current financial and economic mess in another way as well. When we talk about the growth rate in the economy, we talk about the real rate of growth -- i.e., the rate of growth after subtracting inflation. If the real rate of inflation is higher than the official rate of inflation, that means the actual rate of growth in the economy is lower than the official rate of growth.

So when the economy grew at 1.2% in the fourth quarter of 2005, 1.1% in the third quarter of 2006 or 0.6% in the first quarter of 2007, the actual growth rate for the economy was close to or below zero. If we weren't in a recession in those quarters, we were near one.

And what did the Federal Reserve, which has managing the economy as the other half of its job, do about these signs of dangerous weakness? Nothing, of course, because by the official growth numbers, as affected by the official inflation numbers, there wasn't any problem.

The very weak actual numbers of economic growth might have provoked earlier measures to stimulate the economy. At the least, they would have raised a red flag on the health of the housing market: How could home sales be booming and prices soaring even as the real economy delivered something near zero growth? Someone at the Fed or in the U.S. government might have asked that.

But they didn't.

Because reality, as measured by the official numbers, distorted the truth of the real economy and the real asset markets. There's no guarantee that fallible human beings presented with accurate data won't make mistakes. Even huge mistakes. But with distorted data, we don't have a chance of getting it right.