Does the Consumer Price Index Accurately Reflect Inflation?

Overview

Inflation remains a back drop to economic news and a warning and indicator for countries on the brink of revolution or reform. When it is too high, its rate is scorned as a bad omen of the market economy (Walden, 2006; Woodhill, 2014). It’s hyper-presence in the Wiemar Republic of Germany created socio-political conditions that gave rise to fascist socialism of Nazi infamy (Bookbinder, 2010). Fizzling out toward the end of the Cold War, it sent the Russian currency into default (Chiodo & Owyang, 2002). Despite its importance, few polled Americans know what inflation is (“Public Knows Basic Facts about Politics, Economics, But Struggles with Specifics,” 2010) and many believe inflation is in double digits (Hickey, 2013). Polls suggest that Europeans are ignorant of it (Sumner, 2013) and the former Chairman of the Federal Reserve wanted to be commemorated for keeping it low during his tenure at the US Central Bank (Shedlock, 2015). In the Spring of 2015, Bloomberg reported that inflation rose 0.2 percent in March for the third month in a row which indicated signs of a recovering economy (“Inflation Shows Signs of Life as Americans Gain Confidence,” 2015).

This indexed number is often used as an economic indicator by the government to change spending on government programs like Social Security (Brandon, 2013) or influence the capital allocation decisions of investors who require compensation for inflation in what is known as the Fisher Effect (Ross, Westerfield, & Jordan, 2007). Historian and Clinton mentor Quigley noted that inflation encouraged economic activity while also serving to redistribute wealth (Quigley, 1966). Detractors and critics question the methods by which inflation is computed and contend that official reports by identifying high prices in the marketplace (Michael Sivy, 2013).

The contrast of these two perspectives required an explanation of inflation and how it is commonly computed using the Consumer Price Index (CPI). The accuracy of this index must also be explored to validate the official perspectives used to measure inflation in the economy. Does the CPI accurately reflect inflation?

A Tale of Two Inflations

Inflation remained a backdrop to many macroeconomic principles. One perspective of inflation described a rise in prices while another view defined it as an arbitrary increase in the supply of money. Both descriptions describe an economic condition without addressing the relationship of those conditions or if one precedes the other.

Economists O’Sullivan, Sheffrin and Perez define inflation as a sustained increase in prices due to an overheating of the economy through excessive growth (O’Sullivan, Sheffrin, & Perez, 2010). Economists McConnell, Brue and Flynn concur with this view (McConnell, Brue, & Flynn, 2009c). The first American who won the Nobel prize in economics, Paul Samuelson, also concluded that inflation should be viewed through the lens of rising prices when he described inflation in the following manner:

After 1939 an American who earned 5 percent yearly on a mortgage found that he was not even holding his own as far as the real purchasing power of the dollar was concerned. United States government savings bonds bought for $75 a decade ago now pay off about $100. But one hundred current dollars have less purchasing power than eighty-five 1954 dollars did then (Samuelson, 1964).

The definition of rising prices as inflation is a modern economic phenomenon owed to the dominance and revolutionary thought of English economist John M. Keynes and his influence of economic theory (Briggs, 2010; Collins & Devanna, 1990). He noted in his ground breaking, General Theory of Employment, Interest and Money,that, “When full employment is reached, any attempt to increase investment still further will set up a tendency in money-prices to rise without limit, irrespective of the marginal propensity to consume; i.e., we will have reached a state of true inflation,” (Keynes, 1936). Keynes view, consistent with modern economists, have not always remained the same. Almost seventeen years previously, Keynes critiqued the nations of Europe with an alternate view of inflation that dealt with the money supply. He echoed the words of Lenin noting that the best way to destroy a nation was to debase its currency by an artificial increase in the money supply which was inflation (Keynes, 1919).

American social reformer and progressive economist Richard T. Ely concurred with Keynes former assessment in an era where in the United States money was an IOU against a precious metal and thus more immune to manipulation. Ely noted in contrast to the increase in prices that paper money was a “more pliable instrument, subject to increase or decrease in quantity according to the needs or caprices of the governments which issue it.” Defining inflation from this distinction of gold and paper money, he continued, “Inflation is an increase in the currency sufficiently large to bring about, within a relatively short time, a marked rise of prices (Ely, Adams, Lorenz, & Young, 1926).

The means by which governments can debase their currency is through a borrowing mechanism and where Austrian economist Ludwig Von Mises offered insight between the rise in prices, wages and the debasement of the currency. Von Mises claimed that governments cannot create additional jobs because they are non productive entities in any economy and thus can only eliminate as many jobs as it could create while he noted this about inflation:

If government spending is financed by borrowing from the commercial banks, it means credit expansion and inflation. If in the course of such an inflation the rise in commodity prices exceeds the rise in nominal wage rates, unemployment will drop. But what makes unemployment shrink is precisely the fact that real wage rates are falling (Mises, 1947).

Modern economics texts largely ignore money supply and credit expansion of states in their definitions of inflation. Instead they shroud their inflationary models of price elevation through Demand-Pull rhetoric and Cost-Push Inflation descriptors (McConnell, Brue, & Flynn, 2009a). Demand-Pull is excessive spending beyond the economy’s ability to produce while Cost-Push comes from increased costs associated with the production of goods and services usually stemmed from higher costs of raw materials and excessive credit issued by a central bank (McConnell et al., 2009a).

The reason for this difference between the two descriptors in the US can be attributed to drastic economic changes that occurred in the early decades of the 20th century. The US saw the abolition of free banking with the establishment of a central private corporate bank known as the Federal Reserve in 1913, the Establishment of the Income Tax by the 16th Amendment to the US Constitution in 1913, and the Federal Government’s ability to tax more than just men with suffrage for women in 1919 (Griffin, 2010; Terrell, 2004). Quigley noted that since banks are able to issue loans several times the value of their reserves at interest, especially at a central bank, these practices are inflationary (Quigley, 1966). The Government’s ability to measure this came from the Bureau of Labor and Statistics (BLS) through a measurement known as the Consumer Price Index which started in 1913 and has been published regularly since 1922 (Lind, Marchal, & Wathen, 2010).

A Tale of Two CPIs

Prior to the turn of the last century then Bureau of Labor, a subdivision of the department of the Interior, created a cost of living index that tracked retail prices and typical family purchases between 1888 and 1890 (Rippy, 2014). When the Bureau of Labor merged with the Department of Labor in 1913, the office grew from a staff of three employees to over 2000 by the last decade of the century. The BLS is responsible the creation and reporting of the Consumer Price Index ((Norwood, 1984).

The Consumer Price Index (CPI) reports on the price of a “market basket” of several hundred consumer goods and services that are purchased by a typical urban consumer from several thousand retailers around the US (McConnell, Brue, & Flynn, 2009b). The Bureau updates the elements of this container every 24 months so that it indicates the most recent patterns of consumer acquisition and measures the inflation the American consumer experiences (McConnell et al., 2009b). In January of 1978 the Bureau began publishing CPI’s for two groups of the population which included the Urban Consumers and Urban Wage Earners (Lind et al., 2010). This means that various government services pegged to different aspects of the CPI will rise differently.

How is Inflation Measured Using the CPI

Inflation is commonly measured in the Untied States by the Consumer Price Index (CPI), which is compiled by the Bureau of Labor Statistics . The CPI reports the price of several hundred goods and services that are purchased by a typical urban consumer. While reporting monthly, and annually, the Bureau of Labor and Statistics updates the Consumer Price Index’s basket of goods and services every 24 months. While O’Sullivan, Sheffrin, and Perez advocate that Anticipated Inflation is preferential and minimal felt in the economy compared to Unanticipated Inflation to which they equate with hyperinflation (O’Sullivan, Sheffrin, & Perez, 2009) controversy of the CPI comes from inclusion of substitution metrics in how the CPI is computed (Kaifosh, 2015). Critics of the government’s published numbers note the various methodologies of computation have changed over the decades from a cost of goods index to a cost of living index and thus allow the US Government to report a lower CPI (Williams, 2013). Economic forecaster, Addison Wiggin expands this thesis noting that the statisticians use Substitution, Hedonics and Geometric Weighting to skew the CPI numbers (Wiggin, 2010). Substitution he states is when you buy hamburger instead of steak and the CPI guru’s reason your cost of beef is the same(Wiggin, 2010). He explains hedonics by noting that the new model of a car may have more features, whistles and bells including an increased cost but the CPI statisticians believe you’re getting the same value(Wiggin, 2010). With Geometric weighting he notes that if the price goes up it counts less and if it goes down it counts more(Wiggin, 2010).

It’s the Money Supply Then

When Central banks issue lines of credit to the treasuries of the world they are influencing the greater outcomes of the economy. When this money is backed only by the future earnings of taxpayers its implementation into the economy fosters crony-ism and upon entry into the market immediately creates inflation (Rothbard, 2009). Austrian economist, Ludwig Von Mises was alone among his contemporaries who were of pre-monetarist, Fisher and Keynesian disciplines in that his careful examination of monetary fundamentals of the policies of a central bank and its manipulation of the supply of money and credit which preceded the Great Depression (Shostak & Mises, 2006). Economist William A. Scott detailed this phenomenon in 1914 noting the chief cause of inflation was the demand obligations against investment securities and other obligations available to the bank because of the increased demand for capital. He claimed that banks protect themselves by selling short on paper (fiat) in exchange for a long collateral like property. When this property required liquidation there was an adjustment of outward prices. He noted, “The evil involved in the forced sales of property caused by inflation is the readjustment of prices through which it is accomplished, and the depression and, sometimes, panic which follow.” He continued, “When the prices of many kinds of property must be greatly depressed in order to induce their transfer to other hands, the machinery of commerce and industry is thrown out of adjustment and is sometimes rendered temporarily useless” (Scott, 1914). The result of this as Mises, Rothbard, and Scott have noted is a market correction sometimes manifesting as a depression or recession.

Conclusion

The Consumer Price Index does not accurately reflect the value of inflation and better indicators can be met by understanding the issuance of money by a central bank. Tying Federal programs to this metric only ensures that persons utilizing this benefit have less buying power tomorrow than they do today. It is a principle which undermines the very social benevolence many welfare programs intended to provide by reducing the buying power of societies most economically vulnerable. It steals capital from the producers and job creators in the economy who compensate the state with their taxes, or create wealth by assuming the risk in investments by entering the market through finance. It empowers a select few and in downward turns of the economy have elasticity to have purchasing power while others do not in mergers and acquisitions over profitable enterprises that were profitable in unmanipulated markets.

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