Why Reported Inflation Seems Different Than Reality
Lance Roberts | Dec 20, 2012 12:30AM ET
The subject of inflation has remained an emotionally charged topic of debate over the last several years. As rising prices for individuals and businesses have negatively impacted their prosperity,reported inflation has remained at very low levels. With the Fed pumping trillions of dollars into the financial system, the fear of much higher inflation as the dollar is debased, has caused gold prices to soar in recent years. As we will discuss momentarily, the issues surrounding government spending, and the massive deficit, have brought the topic of inflation to the forefront of the political debate.
However, a bit of history is needed for context. The government produces a measure of inflation called the consumer price index (CPI) which is generally broken down into two reports: Headline and Core. The only difference between the two measures is that the core reading strips out the volatile food and energy components. It is this core reading that economists, and the Fed, focus on much to the aggravation of average consumers who quickly point to the fact the food and energy are big part of their daily lives.
The sole purpose in measuring inflation is to help businesses, individuals and government adjust their financial planning for the impact of inflation. Inflation erodes future purchasing power, and decreases economic prosperity, if not accurately accounted for. The accuracy of measuring inflation, and accounting for it properly, is essential to long term economic prosperity.
The original calculation of CPI, which measured the change in the cost of an identical fixed basket of goods priced at prevailing market costs each period, worked reasonably well for the intended purpose into the early-1980’s. However, as the pressure of increasing deficits weighed on political parties, the need to find solutions to reducing spending, without actually cutting spending, led to several substantial changes in the calculation of inflation.
Shortly after Clinton entered the White House the Bureau of Labor Statistics (BLS) altered the calculation of inflation by changing the weighting of goods in the CPI fixed basket. Then, over subsequent years, the method of weighting the underlying components was changed from a straight arithmetic weighting method to geometric. The primary result of the switch to a geometric weighting was a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price which led to lower reported inflation.
According to Doug Short , we will be introducing an inflation index which will be reconstructed along the same lines as the original form of CPI using an arithmetically weighted calculation on a fixed basket of goods. It is hoped that from this experiment we can establish a baseline from which we may be able to ascertain the actual impact of the current environment on incomes, spending and the economy. Stay tuned.
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