Prices are Falling in the Eurozone, but is it “Real” Deflation?

The Eurozone has been on the brink of deflation for months. The latest data show that for the first time, consumer prices for the currency area as a whole (and for 12 of its 19 member countries) were actually lower in December than a year earlier. But is it “real” deflation?

In a pair of posts [1] [2] last fall, when EZ inflation was merely low, but not yet negative, I explained that there are two kinds of deflation.

The nasty kind of deflation, which everyone rightly fears, is driven by falling aggregate nominal demand. As demand collapses, it drags both real output and the price level down with it. There is a serious risk of a self-reinforcing downward spiral in which debtors can’t repay their loans, defaults and falling asset prices undermine the financial system, zero interest rates render monetary policy powerless, and rising unemployment sparks social unrest.

However, there is also a benign kind of deflation, driven by rising productivity. In that scenario, conservative monetary policy restrains the growth of nominal GDP while real output surges ahead. The rate of inflation is negative, but growing output provides borrowers with the cash flow they need to repay their loans, rising productivity allows real wages to rise, and nominal interest rates, although low, do not need to fall all the way to the zero bound. In the US and UK, such productivity-driven deflation was the norm during much of the nineteenth century and reappeared again, more briefly, in the prosperous 1920s.

So which kind of deflation is Europe facing now? The bad, demand-driven kind,  or the good, supply-driven variety? A little of each, it seems.

The good news is that the recent transition from positive to negative inflation for the EZ as a whole comes largely from the supply side via falling energy prices. As the next chart shows, core inflation—the CPI with energy stripped out—remains positive.

For an importing area like the EZ, the impact of falling oil prices is much the same as that of productivity growth. To understand why, imagine that the EZ were a closed economy that produced all of its own oil, and that some technological breakthrough doubled the productivity of the oil industry. Only half as many resources as before would be needed  to sustain oil output; the rest could go to producing other goods and services. The only difference is that currently we are not looking at a decrease in resources needed to produce oil, but instead, a decrease in the resources needed to produce the goods and services that are traded for oil.

The  bad news comes in the form of two big “ifs:” Falling oil prices could theoretically lead to steady growth combined with falling prices, but only if the improvement in terms of trade were sustained, and only if the economy were otherwise healthy to begin with. Unfortunately, we can’t count on either.

Oil imports into the Eurozone amount to about 4 percent of GDP. Roughly speaking, then, the fall of oil prices by half in recent months could be expected to have a beneficial impact equivalent to a 2 percent growth of productivity for the economy as a whole. That is very welcome, but oil prices are not going to fall in half again next year and the year after that. Instead, they are going to stabilize and then rise at least part way back toward the $100 mark. In contrast, the productivity gains that led to growth with falling prices in the nineteenth century and the 1920s continued year after year.

Furthermore, the EZ economy was far from healthy before oil prices began falling. It came into 2014 with inflation under 1 percent and falling, real growth under 1 percent and stagnant, and unemployment stubbornly stuck above 10 percent. Even before oil prices began their plunge in the second half of the year, the Eurozone was already on the brink of a malign deflationary spiral driven by inadequate demand. Several of its members were already over the brink.

So back to our question: Should we call what is happening right now in the Eurozone “real” deflation? Not quite. Right now  both the supply and the demand side of the economy are driving inflation lower, but demand is not yet weak enough to cause outright deflation by itself.

In a best-case scenario, Europe’s fiscal and monetary authorities could take advantage of the oil price windfall to reverse their policies of demand restraint. They could, for example, simultaneously ease budgetary austerity and pursue a program of all-out quantitative easing. By the time oil prices inevitably started to rise again, the underlying economy might be on the road to recovery.

In the worst case, the window of opportunity will close again without anything having been done. If that happens, the threat of a “real” demand-driven deflationary spiral will still be there.

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commented 2015-01-29 07:43:40 -0500 · Flag
Chris R reposts a long four-year-old post from Zero Hedge. Among other things, it includes this passage:

“And since there are two sides to every story, here is reader Dave Narby
following up with an MIT teammember, and getting direct feedback in the
aftermath of our post from Friday disclosing the effective culling of the
MIT Billion Price Project. [ [ EGD: Here is the link, missing in Chris’s version ”http://www.zerohedge.com/article/mit-tepcoes-its-billion-prices-project">http://www.zerohedge.com/article/mit-tepcoes-its-billion-prices-project ] The response may stun some people as to why MIT canceled any relevant public disclosure from the Billion Price Project."

A reader would get the impression from the cited post that the MIT project stopped publishing the US internet based index in 2011 because it was rising too fast relative to the official CPI. Rest assured! The US index is still there, and it is not in fact rising faster than the CPI. In fact, if you check it out, it has recently been falling while the CPI has been rising: http://bpp.mit.edu/usa/

Speaking of Internet-based price indexes, it is interesting to note that in countries that really manipulate their CPIs, the Internet indexes pick up the falsification quite clearly. Here is a link to the Argentine data: http://www.inflacionverdadera.com/
commented 2015-01-29 07:24:04 -0500 · Flag
Chris R asks: “who recalibrates the ‘utility/satisfaction curve’ for the
rank&file consumer… what is the proof of quantified higher utility?”

An excellent question. We should not depend on government to recalibrate our utility curve—better for each of us to do that ourselves. This post explains an excellent way to start doing that yourself, using easily accessible data that is impossible to manipulate: “Finally Proof, Real Proof (Not Just Data) of What Inflation has Done to Our Economy,” http://www.economonitor.com/dolanecon/2012/03/08/finally-proof-real-proof-not-just-data-of-what-inflation-has-done-to-our-economy/
commented 2015-01-29 07:13:42 -0500 · Flag
Chris R writes: “unfortunately we are dealing with an establishment economist (E. Dolan would likely hold any austrian economist in complete, contempt”

I hope that Chris does a better job researching the CPI than he does my resume. He is perhaps unaware that I was the editor of Foundations of Modern Austrian Economics, the conference-based book that re-introduced Austrian economics to the world when it was dying 40 years ago, or that I was invited as keynote speaker to the annual Austrian Economics Research Conference at the Mises Institute last March. I am critical of some details of the work of some individual Austrian economists but in my view, the school as a whole, in both its older and modern versions, has made invaluable contributions to our profession.
commented 2015-01-28 10:44:53 -0500 · Flag
Chris R. writes:

Last addition, obvious and important… govt.-recognized CPI doesn’t include:
  • industrial prices (because retail price supposedly reliably reflects accurate upstream pricing dynamics!!??!)
  • asset prices (because they’re irrelevant to people navigating the real world and never impact the prices of goods+services, do they…?)


Inanity. Yet embraced by ‘consenseless’.
commented 2015-01-28 10:27:43 -0500 · Flag
John D. writes:

how big a factor has “owners equivalent rent” become vs older methodology?
hedonics is a touchy subject, while chris may be correct on his steak v. chicken analogy
not sure so straightforward on consumer appliances, esp the automobile
education is another biggie, US student basic qualifications & testing v. the world has gone pear shaped, even as spending has skyrocketed.
commented 2015-01-28 10:22:59 -0500 · Flag
Chris R. writes:

unfortunately we are dealing with an establishment economist (E. Dolan would
likely hold any austrian economist in complete, contempt… it’s these kind
of guys that hayek, in his [1973?] nobel acceptance speech rightfully
labeled practitioners of ‘scientism’) who assumes you aere obtuse and
unqualified due to your PHD-deficiency. “…And while I think the Bureau of Labor Statistics and Bureau of

Economic Analysis do fantastic jobs of collecting and distilling inflation
data, I also look at—and point critics to—more straightforward assessments
like the Billion Prices Project (2014) from the Massachusetts Institute of
Technology. This tool scrapes the Internet for prices, giving a daily
reading of, well, billions of prices of myriad products. It lacks the
complicated adjustments and methods that characterize the government
agencies’ models. Nonetheless, it does track pretty closely with the
official numbers. What’s more, it gives an independent assessment of
consumer prices that is helpful for those who may distrust official federal
data. While the BPP’s numbers run a tad higher on average than the official
indices, it shows that price inflation remains low and shows no sign of
taking off…"
(source: http://www.zerohedge.com/news/2014-10-20/economic-outlook-keeps-getting-better-and-better-says-fed-president-who-last-week-un)

MIT’s billion price project… a worthy endeavor but… it scrapes prices
for a multitude of goods/servives from the internet… how is it possible
that one can access internet quotes for representative prices of:
  • education
  • healthcare
  • fuel
  • food
  • housing


and each of these items have soared over the last 20 years, yet the CPI and
the BPP are roughly equivalent??

i would ask the good PHD Dolan if he’s paying the same or lesser prices for
each of the above prices as he was 5/10/15/20 years ago.

and how does he reconcile — empirically — the government’s use of:
  • hedonics (who recalibrates the ‘utility/satisfaction curve’ for the
    rank&file consumer… what is the proof of quantified higher utility?)
  • substitution (how does the government prove that yesterday’s steak is of
    the same utility to john q. public as today’s chicken?)
  • weighting (how do you empirically prove the miniscule weighting
    healthcare gets is representative of a true basket of expenditures for a
    average US resident?)
  • why were inflation measures — pre-boskin (i.e. pre-1980) —
    methodologically radically different than today; and does he posit that
    boskin himself, when he stated that he had been given the mandate to
    recalibrate inflation indices to bring down the COLA adjustments on federal
    entitlements, was actually just goofing, and the reason the hedonic,
    substituting, weighting games began was for some other altogether more
    ennobled federal goal??



+
(source:
http://www.zerohedge.com/article/why-mit-not-willing-unleash-real-time-dynamic-purchasing-inventory-control-systems-or-real-r)

Why MIT Is Not Willing To Unleash Real-Time, Dynamic-Purchasing Inventory
Control Systems; Or The “Real” Reason For The Culling Of MIT’s Billion
Prices Project
Submitted by Tyler Durden on 04/24/2011 14:05 -0400

from Kevin Price

Is MIT willing to unleash real-time, dynamic-purchasing inventory control
systems?

A graduate student playing around with a billion dollar price project has
unwittingly stumbled upon the financial equivalent of the internet, and it
was Zero Hedge where the implications of this financial search engine were
reported first. The implications are enormous. This could be what Alan
Greenspan called “a once in a generation acceleration in productivity,” but
only if MIT allows widespread use. Instead it appears that MIT is going to
keep it secret to benefit the oligarchs and the connected at the expense of
the many.

Imagine real time continuously updated pricing data on all available
products, raw inputs, and professional services. This new financial search
engine has the ability to track anything. How about product pricing at Wal
Mart? Drill bits, rolled steel, truckloads of wheat at the grain elevator
level? You see you can monitor in real time the input costs and output
prices of any industry or specific corporation. You could monitor your
competitor and as soon as he has a sale your financial search engine will
alert you and automatically match his prices.

The implications don’t stop with the above. If Wall Street financial
oligarchs ( regulated utilities, like your nice local water company in
Bernanke-speak), have this capability and no one else has it, then they can
monitor in real time prices of all sorts of products, services, and
non-exchange-traded commodity goods. They can watch the trends of input
costs and output prices in real time and front run everyone. The pricing
efficiencies that always go to the consumer in a free market are now
exploited to the detriment of the consumer and the benefit of the small
number of people who have access to MIT’s financial search engine.

As a business you can monitor all of your input costs in real time. You
can monitor by region, industry, specific supplier. The search engine will
also have advanced statistical features to give you directional
probabilities of pricing in the short term. Instead of a rigid,
just-in-time inventory approach to your inputs, your program will alert you
when the likelihood of waiting one more week to buy, or buying one week
early, will give you a better price.

Now imagine if MIT and the financial oligarchs don’t allow widespread
adoption of this information technology. Instead they sell subscriptions
to various businesses. These businesses will now be able to buy their
inputs at a lower than average price, compared to a competitor without this
technology. This brings supply chain management to a whole new level. If
your competitor is unaware you have this technology, then you can always
beat his price, match his sales instantly, and then put him out of
business. The end result of uneven distribution of this information
technology will be to ultimately limit competition. The pricing
efficiencies that would accrue to the consumer if this technology were
widely adopted would go to the financiers and the specific company, as they
capture pricing efficiencies in the short term that drive others out of
business.

An integrated oil company may need to monitor in real time the pricing of
various drill bits. The oil company will buy a little early when
statistical analysis gives a greater than 50 percent probability that price
increases will continue for the next few weeks, and will defer purchasing
when price monitoring suggests a continued drop in drill bit prices over
the next few weeks.

Welcome to real-time, dynamic- purchasing inventory control systems!

In the long run if this technology is distributed fairly to the public it
will result in greater pricing efficiencies as volatility of input costs
diminish. In a competitive market these productivity improvements always
go to the benefit of the consumer, because any excess profits over the
marginal return will quickly signal competitors and supplies to adjust.
This is why Luddites are always wrong about improved productivity.

We now have real time, lightning fast, pricing information. This will
be the greatest thing since the invention of the world wide web. If MIT
does the right thing and announces their discovery to the world, they
can still make a lot of money and also be responsible for one of the
greatest improvements in productivity in history. Imagine what a single
graduate student can do. This is why I am always optimistic about
mankind’s future.

However, if MIT continues to lie about why
they are no longer making the data available, then this will be used to
decrease competition and allow front-running
by financiers as they alone are able to watch in real time pricing
trends for specific industry, or even a specific business located in a
small town near you.

The pricing efficiencies which should ultimately accrue to the benefit of
all mankind will be captured by the oligarchs and select businesses willing
to sign confidentiality agreements. We cannot allow this to happen. Long
live the internet and the blogosphere because secrets cannot be kept long.
Information should be free, or at least priced competitively!

I call upon all of you who realize the implications of MIT keeping this
amazing discovery secret to inform Google, BAIDU, Yahoo, Microsoft, and
every damn business school in the world. The reason why MIT must keep it
secret is because the barriers to entry are low. Anybody can do this.
With a small server farm you can compete with MIT and drive down the price
so that it is available to everyone, even Joe the plumber who wishes to
monitor his input costs and competitor’s pricing. He will pay 200 bucks
per year for this data, especially if it has some value added statistical
analysis that will give him the probability of near term price changes so
he can manage his inventory better.

Don’t let the oligarchs use this to cement financial control. Don’t let
MIT go over to the dark side. Tell the BRIC countries. Tell everyone.
The wonders of a financial search engine should not be used to gouge
society, but to benefit society.

And since there are two sides to every story, here is reader Dave Narby
following up with an MIT teammember, and getting direct feedback in the
aftermath of our post from Friday disclosing the effective culling of the
MIT Billion Price Project. The response may stun some people as to why MIT
canceled any relevant public disclosure from the Billion Price Project.
(emphasis added)
commented 2015-01-28 10:08:02 -0500 · Flag
Ed K. writes:

Does sales tax factor into these items? I read that state sales taxes have risen substantially in the last decade on everything from health insurance (ACA doubled the premium tax on health insurance) to cell phone bills to car registration. Doesnt that need to be factored in?
commented 2015-01-28 10:07:20 -0500 · Flag
Alexander writes:

After reading all of you gentlemen’s retorts and articles I am reinforced in my original position that the CPI – as currently measured – is a manipulated, corrupted, and generally falsified piece of misinformation used to soothe the Sheeple into believing that the Elite Ruling Class is benevolent and competent caretaker of the nation’s economy.
commented 2015-01-26 16:25:13 -0500 · Flag
John D. writes:

unsure why we have to defend what I think we have all already proven to be at best dodgy & at worst outright consumer fraud.
commented 2015-01-26 16:13:12 -0500 · Flag
Alexander Ackley writes:

Go Here for the facts: http://www.shadowstats.com/

Have you ever wondered why the CPI, GDP and employment numbers run counter to your personal and business experiences? The problem lies in biased and often-manipulated government reporting.
Primers on Government Economic Reports What you’ve suspected but were afraid to ask. The story behind unemployment, the Federal Deficit, CPI, GDP.

Alternate Unemployment Charts
The seasonally-adjusted SGS Alternate Unemployment Rate reflects current unemployment reporting methodology adjusted for SGS-estimated long-term discouraged workers, who were defined out of official existence in 1994. That estimate is added to the BLS estimate of U-6 unemployment, which includes short-term discouraged workers.
The U-3 unemployment rate is the monthly headline number. The U-6 unemployment rate is the Bureau of Labor Statistics’ (BLS) broadest unemployment measure, including short-term discouraged and other marginally-attached workers as well as those forced to work part-time because they cannot find full-time employment.

Alternate Inflation Charts
The CPI chart on the home page reflects our estimate of inflation for today as if it were calculated the same way it was in 1990. The CPI on the Alternate Data Series tab here reflects the CPI as if it were calculated using the methodologies in place in 1980. In general terms, methodological shifts in government reporting have depressed reported inflation, moving the concept of the CPI away from being a measure of the cost of living needed to maintain a constant standard of living.
Further definition is provided in our CPI Glossary. Further background on the SGS-Alternate CPI series is available in our Public Comment on Inflation Measurement.

CPI Year-to-Year Growth
The CPI-U (consumer price index) is the broadest measure of consumer price inflation for goods and services published by the Bureau of Labor Statistics (BLS).
While the headline number usually is the seasonally-adjusted month-to-month change, the formal CPI is reported on a not-seasonally-adjusted basis, with annual inflation measured in terms of year-to-year percent change in the price index.
In the charts to the right we show two SGS-Alternate CPI estimates: One based on the pre-1990 official methodology for computing the CPI-U, and the other based on the methodology which was employed prior to 1980.
Please note: Our Data Download is currently only providing the 1980-Based numbers, but 1990-Based numbers will be introduced shortly.

Money Supply Charts
The Fed ceased publishing M-3, its broadest money supply measure, in March 2006. The SGS M-3 Continuation estimates current M-3 based on ongoing Fed reporting of M-3’s largest components (M-2, institutional money funds and partial large time deposits) and proprietary modeling of the balance. See the Money Supply Special Report for full definitions.

Changes in money supply have implications both for domestic economic activity and inflation, as discussed in the previously mentioned Money Supply Special Report.
Here we show year-to-year growth as a measure of the changing money supply.
Note: A downward slope in this growth curve does not necessarily mean that the money supply is dropping. Only if the curve goes below zero does that show money supply having contracted over a full twelve months.
Also, for money supply changes over periods of less than a year, such need to be viewed on a seasonally-adjusted basis. Unadjusted change over short periods may show changes that are little more than regular seasonal variations. Short-term changes also may run counter to year-to-year change, as seen in the latter part of 2009, for example.
Money Supply Level
See our further charts for the estimated levels of money supply. The monthly-average data are seasonally adjusted.
commented 2015-01-26 06:57:58 -0500 · Flag
Facts and figures and methodology – OK. Importance of right measures – plus understanding and definition thereof. CPI is a key figure. And there is reason to debate that. Its construction, its change in contents and weight, … its politically/statistically wanted make-up, … its comparability, … its significance for/in reality.

However, could it be that the discussion – also outside this forum, in politics, economy, and science – has elements of faith, i.e., belief in what is considered the right theory and hypotheses, not only due to different views about the correctness of numbers?

What about the underlying assumptions that contribute to perceiving deflation, the two types mentioned, as an immenent danger? Political and economic beliefs are also shaped by theories of behavior. Also because they deal with the “human factor”, who is not fully accountable by figures (take the impact game theory, e.g., has for various economic issues and complements “hard science”).

Specific and aggregated figures are one result of human activity. Human activity itself, however, is not only of greater interconnections and dynamics, i.e., of greater variety, change, and complexity. It it more difficult to grasp, comprehend, and predict than formulas and statistics. There remains uncertainty – and with it ample of room for different arguments and interpretations.

With falling, as already with fallen prices, people (consumers and industry) will not spend or invest, because they expect/bet on (even) cheaper prices? Is consumption and investment on “stop” because of “deflation”? Really?

And is it not also a difference what money is spent for (i.e. infrastructure “better” than “just” consumption, because it contributes to strenghtening the base from which future growth, and spending, can arise)? And what about areas where the price can hardly sink any more, like interest rates if/when credits are used or necessary to consume/invest?

For an account of reality, various strands have to try to be welded together to form a realistic image: Key figures, their relation to each other, their timely change/development; and assumptions and theories behind the choice for/selection of such figures in the first place.
commented 2015-01-26 05:00:33 -0500 · Flag
It is a delight to see the quality of this ventilation of economic myth and theory taking place on the blog of the International Chronicles. Prof. Ed Dolan is contributing to the growth of economic understanding with every sentence.
Thanks to one and all for this exchange.
commented 2015-01-25 16:47:21 -0500 · Flag
John D writes: “Is Mr. Dolan serious? Then he is either a tenured government lifer/lackey or a fool”

I guess the right answer is that I am a fool, because I am about to do something only a fool would do, which is to try to give a serious answer to someone like John D.

John D Writes:
“The Consumer Price Index Is Controversial The Consumer Price Index (CPI) is produced by the Bureau of Labor Statistics (BLS). It is the most widely watched and used measure of the U.S. inflation rate. It is also used to determine the real gross domestic product (GDP).”

Simply false. The GDP uses a separate methodology for calculating real GDP, called the GDP deflator. It has nothing to do with the CPI, although over time, the two show roughly similar rates of inflation.

John D Writes:

“The period since 2005 appears to show 3% as the reported CPI and 9-10% as the true inflation”

I don’t think John D has thought this through very clearly or tried to do the math. Official statistics show (very roughly speaking) that real wages have been about constant over the past 30 years, allowing (very roughly speaking) 3 percent for inflation. If the true inflation rate were really 10 percent, then that means that the price index over 30 years would rise not from 100 to 235 but from 100 to 1586, or by about six times as much. That is equivalent to asserting that the average wage earner now has a standard of living just 1/6 that of the average wage earner of 30 years ago. Even people who think life was better back in the good old days of the 1980s don’t seriously think it was SIX TIMES better.

Finally: I suggest that readers who think that the CPI overstates or understates inflation by a huge amount should compare it with the non-government “Billion prices” index put out by MIT. That index takes prices off the internet, completely bypassing any possibility of government manipulation. Surprise surprise! It tracks the CPI very closely. Check the chart and methodology here: http://bpp.mit.edu/usa/

For more on price indexes, how to interpret them, and why some people don’t believe them, see these earlier posts on my blog:

If inflation is quiet, why are people still feeling it’s pain? http://www.economonitor.com/dolanecon/2012/05/18/inflation-is-quiet-so-why-are-people-still-feeling-its-pain/
What does the CPI measure? Inflation or cost of living? What’s the difference?

http://www.economonitor.com/dolanecon/2014/07/23/what-does-the-consumer-price-index-measure-inflation-or-cost-of-living-whats-the-difference/
commented 2015-01-25 16:41:18 -0500 · Flag
DeRoi P writes:

“Allowing substitution of lower-priced and lower-quality goods in the basket (i.e. more hamburger when steak prices rise) lowers the reported rate of inflation versus the fixed-basket measure.”

That line is a favorite of CPI critics, but it is simply false. Here is what the BLS actually does: (source: http://www.bls.gov/cpi/cpiqa.htm )

“When the cost of food rises, does the CPI assume that consumers switch to less desired foods, such as substituting hamburger for steak?

No. In January 1999, the BLS began using a geometric mean formula in the CPI that reflects the fact that consumers shift their purchases toward products that have fallen in relative price. Some critics charge that by reflecting consumer substitution the BLS is subtracting from the CPI a certain amount of inflation that consumers can “live with” by reducing their standard of living. This is incorrect: the CPI’s objective is to calculate the change in the amount consumers need to spend to maintain a constant level of satisfaction.

Specifically, in constructing the “headline” CPI-U and CPI-W, the BLS is not assuming that consumers substitute hamburgers for steak. Substitution is only assumed to occur within basic CPI index categories, such as among types of ground beef in Chicago. Hamburger and steak are in different CPI item categories, so no substitution between them is built into the CPI-U or CPI-W.”
commented 2015-01-23 19:00:11 -0500 · Flag
Thomas N. writes:

It IS ALL based on spurious substitution, like today, I couldn’t afford regular potatoes, so I bought powdered potatoes (30% Less than the genuine root), just Add water and voilà, works for the Government doesn’t work for me, they taste like shit, Now shut up and eat your porridge !
commented 2015-01-23 18:58:44 -0500 · Flag
Delroi P. writes:

the CPI as it exists today is entirely spurious: a measure of the price of
survival, not the price of a constant basket of utility curve-stable goods
& services.

yes, ‘food’ is included, but its substitution is never accounted for (i.e.
steak bought for dinner in 1960, alpo bought for dinner in 2015… both
keep you alive but they occupy far different positions on the
satisfaction/utility curve even though they are both sustenance).

‘housing’ is represented, via ‘owners’ equivalent rent’, which is plagued
by a myriad of distorting factors. health care and education are entirely
gamed… see below…


+
Summary of Real-World Needs versus Theoretical Constructs of Academia
  • While the 1990s saw the push to reduce official inflation reporting, by shifting from a fixed-weight to at least a quasi-substitution-based CPI,
  • less-publicized actions were taken to reduce CPI reporting through the introduction of hedonic quality adjustments, starting in the 1980s.
  • Maintaining Constant Standard of Living (Fixed-Basket Inflation) versus Substitution in CPI


Since the 1700s, consumer inflation has been estimated by measuring price changes in a fixed-weight basket of goods, effectively measuring the cost of living of maintaining a constant standard of living. Allowing substitution of lower-priced and lower-quality goods in the basket (i.e. more hamburger when steak prices rise) lowers the reported rate of inflation versus the fixed-basket measure. BLS introduced: Geometric weighting—a purely a mathematical gimmick that automatically reduces the weightings of goods rising in price, and vice versa—it has no demonstrated relationship to consumer substitution of goods based on price changes. It was explained as a surrogate for a substitution measure. BLS introduced: More frequent re-weightings of the CPI index from every ten years to every two years, which moved the CPI closer to a substitution-based index, but the change was not considered a change in methodology. BLS introduced: Ongoing re-weightings of sales outlets (discount/mass-merchandisers versus Main Street shops), also moving closer to a substitution-based index and creating other constant-standard-of-living issues.

Out-of-Pocket Expenses versus Nebulous Quality (Hedonic) Adjustments
Traditionally, what a consumer paid out-of-pocket for goods and services reflected adjustments for quality changes that could be directly quantified in a monetary sense. Quality adjustments that can be measured directly in price are legitimate, such as measuring the price differential of an eight-ounce candy bar that is reduced in size to six-ounces but remains priced and packaged in the same sized box as the eight-ounce version. The BLS expanded quality adjustments to include the concept of “hedonic” quality adjustments, altering the pricing of goods and services for nebulous quality changes that often were not viewed or recognized by consumers as desired improvements. Where the effect here on the pricing of goods and services could not be quantified directly from a pricing standpoint, the pricing impact was estimated by computer statistical modeling—hedonic adjustment modeling—that had little if any relevance to real-world experience. Where the quality of the product was deemed by the government to have improved (the usual circumstance), prices in the CPI calculations were adjusted lower to offset the higher quality. Usually, though, the purchasing consumer only had the option of paying out-of-pocket the full price for the product, again with little or no concept of the quality improvement being acquired and/or having no chance to opt out of paying for the improvements. In an early example, the government mandated the use of a gasoline formulation that purportedly would improve auto emissions. That added ten cents per gallon to gasoline costs, but that cost was excluded from CPI calculations. The person filling his or her gas tank, however, suffered the actual out-of-pocket expense. The government later abandoned excluding government-mandated “quality” improvements, such as gasoline additives, from inflation calculations, but the principles here were exactly the same for industry-generated “quality” improvements that were not optional to consumers. Text books, for example were modeled, where one pricing factor in the hedonic quality model was whether or not there were color pictures in a book. Unless the student was an art student, the concern usually was not over colored pictures, but rather along the lines of “What is my out-of-pocket cost for textbooks this semester?” New computer features usually were deemed quality improvements, with downside price adjustments made in the CPI for the changes, even though a consumer may not have wanted or used the features. The consumer still had to buy those features and pay full cost out-of-pocket, irrespective of what the government determined those products were generating in purported hedonic quality benefits that the consumer was not considering or using. Significant feature changes should be treated as a new product introduction, or otherwise ignored. If the use of the hedonic process were legitimate here, it would be applied to all goods and services, but a CPI, so based, soon would become meaningless to the public (as already has happened with the CPI-U). For example, there has been no pricing adjustment (upside in this case) to the costs of air travel for the destruction of travel convenience with the advent of the TSA, or from the downward spiral in U.S. air traveler comfort and convenience resulting from the effects of mergers and acquisitions, and from increasing flight delays due to economizing on aircraft maintenance. Consumer concerns are for his or her out-of-pocket expenses.

What am I paying for my textbooks this semester; what am I paying out-of-pocket to fly from New York to Chicago; or what am I paying out-of-pocket for a computer, even if I am looking just to use limited functions but have no choice but to buy unwanted features?


+
there are three major statistical “tricks” that the BLS imposes on the
Consumer Price Index. They are hedonics, which tries to account for
improving quality in products over time; substitution, which is the act of
switching to lower-cost items when prices surge on preferred items; and
weighting.

For less-than-satisfactory reasons, the BLS only weights health care at
6.5% of the CPI, although it represents 17.6% of the total GDP. That’s a
big problem, because health care is the biggest and most consistent source
of inflation over the years.

A big portion of the underweighting of medical care can be attributed to a
single category: health insurance, which stands at just 0.49% of the total
CPI reading, or less than half a percent:

According to the BLS, the average family is projected to have a total
exposure to rising health insurance premiums at a rate of only 0.49% (out
of 100%). Given a median family income of $49,077 (the 2009 value), this
means that the BLS assumes that the average family contributes just $239
dollars per year towards their health care insurance premiums. Yes, I wrote
per year, not per month. That’s not a typo.

Worse, and compounding this error of weighting, the BLS has somehow
calculated that the cost of health insurance has been steadily falling for
the past three years:

Apparently health insurance rose from 2005 to 2007 and has been in a
sustained downtrend ever since. By this measure health insurance is now
just 4% higher than it was in 2005, a full five years ago.

In the full report on this subject I go through the supporting data that
reveals just how egregiously off the mark this BLS data set is (the gap is
well over 100%), but I hope that everyone knows just how wrong this data
has to be without much more evidence.

In just those two errors, under-weighting health care and inexplicably
concluding that health insurance has been steadily falling for three years,
by my calculations the BLS is understating inflation by a full 3%.
commented 2015-01-23 18:02:47 -0500 · Flag
John D. writes:

And more proof: http://www.investopedia.com/articles/07/consumerpriceindex.asp Why The Consumer Price Index Is Controversial The Consumer Price Index (CPI) is produced by the Bureau of Labor Statistics (BLS). It is the most widely watched and used measure of the U.S. inflation rate. It is also used to determine the real gross domestic product (GDP). From an investor’s perspective, the CPI, as a proxy for inflation, is a critical input that can be used to estimate the total return, on a nominal basis, required for an investor to meet his or her financial goals. For several years, there has been controversy about whether the CPI overstates or understates inflation, how it is measured and whether it is an appropriate proxy for inflation. Read on to learn more about how the CPI affects investors. The Controversy Originally, the CPI was determined by comparing the price of a fixed basket of goods and services in two different periods. Determined as such, the CPI was a cost of goods index (COGI). However, over time, the U.S. Congress embraced the view that the CPI should reflect changes in the cost to maintain a constant standard of living. Consequently, the CPI has been moving toward becoming a cost of living index (COLI). Over the years, the methodology used to calculate the CPI has also undergone numerous revisions. According to the BLS, the changes removed biases that caused the CPI to overstate the inflation rate. The new methodology takes into account changes in the quality of goods and substitution. Substitution, the change in purchases by consumers in response to price changes, changes the relative weighting of the goods in the basket. The overall result tends to be a lower CPI. However, critics view the methodological changes and the switch from a COGI to a COLI focus as a purposeful manipulation that allows the U.S. government to report a lower CPI. John Williams, a U.S. economist, described his view of this manipulation when he was interviewed in early 2006. Williams prefers a CPI, or inflation measure, calculated using the original methodology based on a basket of goods having quantities and qualities fixed. David Ranson, another U.S. economist, also questions the official CPI’s viability as an indicator of inflation. Unlike Williams, Ranson doesn’t espouse the viewpoint that the CPI is being manipulated. Instead, his view is that the CPI is a lagging indicator of inflation and is not a good indicator of current inflation. According to Ranson, increases in the price of commodities are a better indicator of current inflation because inflation initially affects commodity prices, and it may take several years for this commodity inflation to work its way through an economy and be reflected in the CPI. Ranson’s preferred inflation measure is based on a commodity basket of precious metals. What is immediately apparent is that three different definitions of the CPI are being used. Since these definitions are not operationally equivalent, each method of measuring inflation would lead to different results. Different CPI or Inflation Levels It does appear that the differing means of measuring inflation produce disparate indications of inflation for the same period. The November 2006 Consumer Price Index Summary, which is published by the BLS, stated that “During the first 11 months of 2006, the CPI-U rose at a 2.2% seasonally adjusted annual rate (SAAR).” Williams’ estimate of CPI for the same period was 5.3%, while Ranson’s reported an 8.2% estimate. The differences between the BLS CPI and the figures attained by Williams and Ranson would be of sufficient magnitude, that if the CPI is being manipulated downward, the outcome of an investment plan could be less than effective. Therefore, a prudent investor may wish to obtain more insight and a better understanding of these disparate views of CPI and inflation measures and the effects they may have on their investment decisions. Implications for Required Return Rates Investors must calculate their total required rate of return (RRR) on a nominal basis, taking into account the effect of inflation. As the inflation rate increases, higher nominal returns must be earned in order to obtain a desired real rate of return. The nominal, annual required total return can be approximated as the real required return plus the rate of inflation. For short investment horizons, the approximate method works well. However, for longer investment horizons (such as 20 or greater years), a slightly different method should be used because the approximate method will introduce additional inaccuracy, which will be compounded as the investment horizon increases. A more accurate estimate of the nominal, annual required total return is calculated as the product of one plus the annual inflation rate and one plus the required annual real rate of return. The following table measures the three respective methods of inflation figures with a 3% desired rate of real return. The results tabulated below clearly show that as the difference between the inflation rate and the real rate of return increases, the difference between the approximated and the accurately determined total required returns increases. Inflation Estimated By BLS Williams Ranson Inflation Rate (i) 2.2 5.3 8.2 Real Rate of Return Required® 3.0 3.0 3.0 i + r (approximate nominal rate) 5.2 8.3 11.2 1-[(1+i)(1+r)] (“accurate” nominal rate) 5.3 8.5 11.5 The effect of these differences is magnified as the investment horizon increases. This is clearly shown in the following table, which contains the value of $1 compounded for 10, 20 and 30 years at the various nominal total required returns determined for each inflation estimate. The first rate of return in each pair is the approximated return and the second rate is the more accurately determined one. - Rate of Return BLS Williams Ranson 5.2% 5.3% 8.3% 8.5% 11.2% 11.5% Value of $1 Compounded for: - - - - - - 10 Years $1.66 $1.68 $2.22 $2.26 $2.89 $2.97 20 Years $2.76 $2.81 $4.93 $5.11 $8.36 $8.82 30 Years $4.58 $4.71 $10.94 $11.56 $24.16 $26.20 Implications for the GDP The GDP, is one of many economic indicators investors can use to gauge the growth rate and strength of an economy. The CPI plays a role in the determination of the real GDP; therefore, manipulation of the CPI could imply manipulation of the GDP because the CPI is used to deflate some of the nominal GDP components for the effects of inflation. CPI and GDP have an inverse relationship, so a lower CPI – and its inverse effect on GDP – could suggest to investors that the economy is stronger and healthier than it really is. Looking Deeper Governments also use the CPI to set future expenditure. Many government expenses are based on the CPI and, therefore, any lowering of the CPI would have a significant effect on future government expenditures. A lower CPI provides at least two major benefits to the government: Many government payments, such as Social Security and the returns from TIPS, are linked to the level of the CPI; therefore, a lower CPI translates into lower payments – and lower government expenditures. The CPI deflates some components used to calculate the real GDP – a lower inflation rate makes the economy look better than it really is. In other words, if the true rate of inflation is higher than the CPI as the government calculates it, then an investor’s real rate of return will be less than originally expected, as the unplanned amount of inflation eats away at gains. Factors Contributing to the Controversy Many of the factors contributing to the CPI controversy are shrouded in complexities related to statistical methodology. Other major contributors to the controversy hinge on the definition of inflation and the fact that inflation must be measured by proxy. The BLS describes the CPI as a measure of the average change in price over time of goods and services purchased by households on an average day-to-day basis. The BLS uses a cost of living framework to guide its decisions regarding the statistical procedures used to determine the CPI. This means that the inflation rate indicated by the CPI reflects the changes in the cost of living, or the cost of maintaining a fixed standard of living or quality of life. In other words, it is a cost-of-living index (COLI). The procedures used by the BLS to calculate the CPI are presented in detail in Chapter 17, titled “The Consumer Price Index”, of the BLS Handbook of Methods. CPI and Consumer Behavior To illustrate a simplified example on the effect of consumer behavior and different calculation methodologies on the CPI, assume the following scenario where substitution occurs at the item level within a category, in keeping with the BLS methodology. Suppose that the only consumer good is beef. There are only two different cuts available; filet mignon (FM) and t-bone steak (TS). In the prior period, when prices and consumption were last measured, only FM was purchased and the price of TS was 10% less than the price of FM. When next measured, prices had increased 10%. A set of prices have been constructed to reflect this scenario and are presented in the table below. Product Price Per Pound Before Increase Price Per Pound After Increase Price Increase Filet Mignon $9.90 $10.89 10% T-Bone Steak $9.00 $9.90 10% The CPI, or inflation, for this contrived scenario is calculated as the increase in the cost of a constant quantity and quality of beef, or a fixed basket of goods. The inflation rate is 10%. This is essentially the way the CPI was originally calculated by the BLS, and it is the methodology used by Williams. This method is unaffected by whether consumers change their buying habits in response to a price increase. The current BLS methodology of calculating CPI takes into account changes in consumer purchasing preferences. In the simplified example presented, if there is no change in consumer behavior, then the calculated CPI would be 10%. This result is identical to that obtained with the fixed basket method used by Williams. However, if consumers change their purchasing behavior and fully substitute TS for FM, the CPI will be 0%. If consumers reduce their purchases of FM by 50% and purchase TS instead, the BLS calculated CPI will be 5%. The previous calculations showed that the CPI methodology used by the BLS, given the scenario and consumer behaviors as described above, result in a CPI that depends on consumer behavior. Furthermore, an inflation level that is lower than an observed price increase can be measured. Although this example is contrived, similar effects in the real world are definitely within the realm of possibility. What Should Investors Do? Investors could use the official CPI numbers, accepting the government reported figures at face value. Alternatively, investors are faced with choosing either Williams’ or Ranson’s measure of inflation, implicitly accepting the argument that the officially reported figures are bogus. Therefore, it is up to investors to become informed on the topic and take their own stance in the issue. Different CPI levels, for a single price increase, depending upon consumer behavior, can be calculated using the BLS methodology, and it is not implausible that, depending upon consumption patterns, different rates of inflation may be experienced by a consumer. Therefore, the answer may be investor specific.
commented 2015-01-23 17:59:34 -0500 · Flag
John D. writes:

And here is more proof:

http://seekingalpha.com/article/226186-cpi-not-a-true-index-of-inflation CPI: Not a True Index of Inflation CPI was an index worth watching before the 1974 return to open gold trading under Gerald Ford and for some time thereafter. But it was then “modified” several times to “properly reflect” true inflationary trends. These modifications — oddly — always resulted in LOWERING the reported rate of inflation. There are massive entitlement programs that use the reported CPI as their mandated benefit-adjustment tool – so it saves billions for the U.S.Gov’t if the CPI is only 0.1% lower. Enough said. Strange how things have changed. Now CPI is being reported at 1%+/- YOY and is dangerously close to falling into negative territory. The fear by the Fed now is that – by using current CPI as a measure – the reports will show deflation. Perhaps the CPI will now be modified again to return to earlier methodologies and show that inflation is truly the case – not deflation. As an easily “modified” index, CPI is not worth tracking today as an inflation indicator, although it is common practice in print and on MSNBC. (See HERE) This is not unlike unemployment stats where, when you remove everyone who has stopped looking for work – and is then chronically unemployed, the reports from the government eliminate them and thus report “unemployment” to not show the percentage of people that would be “employed” under a better economy. You would think it would make common sense to include all “unemployed” in the “unemployment stats” — but common sense and government reports don’t always go for walks on the beach arm-in-arm. Enlightened Economics (HERE) discussed in 2008 how CPI has been “adjusted” over time by the government to hide real inflation. The following is a more up-to-date plotting of CPI vs. an alternative measure, starting in 1983, when the first “modification” was made to CPI. Readers will note how the disparity then accelerated in 1993, at the last modification. The period since 2005 appears to show 3% as the reported CPI and 9-10% as the true inflation (as CPI was measured prior to 1980). http://www.shadowstats.com/alternate_data/inflation-charts For another discussion of measures of inflation (i.e. devaluation of the currency), see “The Gold-Suit Index”.
commented 2015-01-23 17:55:11 -0500 · Flag
John D. writes:

Is Mr. Dolan serious? Then he is either a tenured government lifer/lackey or a fool (or both). Here is an article from FORBES last year…the CPI is most definitively NOT a valid “inflation” measurement for the everyday citizen:

Common sense tells us the Consumer Price Index is not an adequate measure of inflation. For the second year in a row the Consumer Price Index for All Urban Consumers (CPI-U) remained under 2 percent. On average, consumer prices increased 1.5 percent, according to the government. However, the government has incentives to keep this statistic as low as possible. In fact, the CPI doesn’t even measure inflation, rather a range of consumer spending behaviors. The CPI is perhaps one of the most important government statistics because it affects a number of public programs and is used as a benchmark to set public policy. But it’s accuracy is questionable, especially when compared with other agency’s inflation measures.

Why does the government want low inflation numbers?

The CPI is tied to the incomes of about 80 million Americans, specifically: Social Security beneficiaries, food stamp recipients, military and federal Civil Service retirees and survivors, and children on school lunch programs. The higher the CPI, the more money the government needs to spend on these income payments to keep pace with the cost of living. However, this same government is about $17 trillion in debt. If the CPI is low, the less money the government needs to spend on cost of living adjustments, something seniors are astutely aware of.

The government has a few resources at its disposal to manipulate the CPI. First, the Bureau of Labor Statistics operates under a veil of secrecy. The raw data used to calculate the CPI is not available to the public. When I asked why, I was told “so companies can’t compare prices.” This makes very little sense because companies can easily compare prices with data openly available on the internet. It also makes it impossible to audit their findings. Additionally, over the past 30 years, the government has changed the way it calculates inflation more than 20 times. These ‘methodological improvements’ to the CPI are said to give a more accurate measure of consumer prices. However, these changes could also be a convenient way to include or exclude certain products that give favorably low results, but there’s no way to know, given the lack of transparency.

So how is the CPI calculated?

Although this is not a transparent process, the BLS gives some insight on their website as to how it calculates the CPI. The economic assistants track about 80,000 consumer products each month known as the Market Basket of Goods. However,

“If the selected item is no longer available, or if there have been changes in the quality or quantity (for example, eggs sold in packages of ten when they previously were sold by the dozen) of the good or service since the last time prices were collected, the economic assistant selects a new item or records the quality change in the current item.”

This data is then plugged into a formula along with other factors including census information and consumer spending patterns. In other words, the CPI doesn’t measure changes in consumer prices, rather it measures the cost-of-living. Further, the government makes the assumption that consumer spending habits change as economic conditions change, including rising prices. So if prices rise and consumers substitute products, the CPI formula could hold a bias that doesn’t report rising prices. Not a very accurate way to measure inflation.

The CPI doesn’t even meet the government’s definition of inflation

The Bureau of Labor Statistics defines inflation “as a process of continuously rising prices or equivalently, of a continuously falling value of money.”

As I outlined above, the CPI is not a measurement of rising prices, rather it tracks consumer spending patterns that change as prices change. The CPI doesn’t even touch the falling value of money. If it did the CPI would look much different.

The CPI doesn’t meet other government agency’s inflation measurements either.

The most obvious is the Federal Reserve’s measure of monetary inflation. M2 measures the supply of US dollars, which includes cash, checking deposits, saving deposits, and money market mutual funds. The more money that’s created and put into circulation, the less valuable it becomes. And the Fed has created a lot of money recently. The Fed’s unprecedented bond buying program, Quantitative Easing, created $116 million an hour for the entire year last year. It doesn’t make sense that the BLS’s measurement of inflation was only 1.5% last year, while at the same time, monetary inflation grew 4.9%.*

Another example where the BLS doesn’t meet other agency’s inflation measurements is the U.S. Department of Agriculture. According to the BLS the average price of beef and veal increased 20 percent over the past five years. However, according to the USDA, beef prices have increased 26 percent over the past five years. I asked a statistician at the BLS about this discrepancy and he said “I would expect those numbers to be a little closer together.” When even the federal government gets different numbers on the same products, how could this possibly be an accurate measurement of inflation?

It’s important to have an accurate measure of inflation because consumers, especially those on fixed incomes, are negatively impacted by rising prices. Also, the federal government and the Federal Reserve use CPI trends to help set tax, monetary and fiscal policies, which affects economic growth. Given that the CPI is calculated secretly, is no where near comparable to monetary inflation, and doesn’t even meet its own definition of inflation, we should use our common sense to count the value of our cents, not the CPI.
commented 2015-01-23 17:40:28 -0500 · Flag
Victor M. writes:

Recently went to drug store to compare how they price a drug my wife uses – cash price 1100 – blue cross blue shield 770 – another provider 480 and mountain health 60.

And I asked about this craziness – he related a story about how a common drug – it’s price had just gone from 8 dollars per 500 to 2,000 per 500! He said they have to push all generic prices as high as can before caps kicked in – dont know if I have whole story right – but the dollar part of the story is 100 percent accurate!
commented 2015-01-20 04:29:14 -0500 · Flag
The news from Ed Dolan´s economic research is welcome and encouraging. A breath of fresh air. Thanks to the International Chronicles for bringing us this message!
commented 2015-01-19 13:16:57 -0500 · Flag
Ed Dolan writes:

Alexander is misinformed, although the misconception is a common one. The official headline CPI figures for both EU and US do include food, energy, and healthcare. The so-called core CPI omits food and and energy in an effort to eliminate short-term volatility, however, the long-term trend of the core and full CPI are very close. Heath care costs are hard to measure, but both the core and the standard CPIs attempt to include them.
commented 2015-01-19 08:39:19 -0500 · Flag
Alexander writes:

Neither Health Care nor Energy nor Food is figured into CPI / ‘Official Inflation’ figures…so what the hell are we measuring here? A more faked, distorted and disproved ‘report’ does not exist in our world…it really has nothing to do with how people live. More Ruling Class corruption and misinformation to manipulate the serf classes into believing that their Elite benefactors are taking care of them splendidly while their standard of living stagnates…
commented 2015-01-19 08:38:44 -0500 · Flag
J.C. writes:

my healthcare just increased 7% for 2015 (up 4.3% for 2014)….luckily for federal apparatchiks, healthcare is not figured into CPI & neither was the increase for school tuition deflation? not on my watch