The Independent Market Observer

9/27/13 – The Inflation Problem, Part 3: Political Statistics?

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Sep 27, 2013 8:21:38 AM

and tagged Market Updates

Leave a comment

“I gather, young man, that you wish to be a Member of Parliament. The first lesson that you must learn is, when I call for statistics about the rate of infant mortality, what I want is proof that fewer babies died when I was Prime Minister than when anyone else was Prime Minister. That is a political statistic.” — Sir Winston Churchill

There are three significant criticisms of the Consumer Price Index (CPI) methodology. The first is that the substitution of items in the basket of goods is not appropriate (the “hamburger versus steak” argument). The second is how to account for changes in the quality of goods sold. The third is the use of rental equivalence to measure housing costs and their contribution to the CPI.

Shadowstats argues that the CPI is underestimated by about 7 percent per year, based on disagreements with the Bureau of Labor Statistics (BLS) methodologies for these three adjustments. If that’s the case, it represents a significant risk to you and your future spending power. We will examine all three criticisms, including the Shadowstats argument and the BLS response, and close with a look at the actual data.

The hamburger versus steak argument can be simply stated: the BLS methodology assumes that if steak gets too expensive, consumers will switch to hamburger, and the inflation rate will reflect that switch by replacing steak with hamburger in the basket of goods. The idea behind the criticism is that the CPI adjusts the basket of goods to reflect relative price levels. In other words, if steak gets too expensive, the CPI calculation substitutes hamburger on the grounds that consumers will switch to hamburger when they can’t afford to buy steak. (Presumably, when hamburger gets too expensive, consumers will switch to pet food, which will then replace hamburger in the index.) According to this argument, the CPI, as calculated, understates inflation, as the changing basket of goods represents a declining standard of living. This argument has been made widely in magazines and on the Internet, most clearly in the Shadowstats primer on inflation.

The BLS is well aware of the criticism and, in the August 2008 Monthly Labor Review, took it on directly: “It must be stated unequivocally that the BLS does not assume that consumers substitute hamburger for steak.” So there! The article explains that any substitution that does occur is within a class—that is, one type of steak for another. Hamburger is in another category—say, “ground beef in Chicago,” not “beefsteak in Chicago.” In fact, the article goes on to say, the change in purchasing is based on relative price changes, so if a more expensive item, like filet mignon, increased by less than flank steak, the basket would actually reweight to the more expensive item.

The BLS provides additional information, with examples of how the strict “basket of identical goods” approach provides an upper limit to the level of price inflation, but it’s probably not the best indicator. So, while the specific example is wrong, the central issue of what constitutes a substitutable item remains. Overall, as the BLS is well aware of the issue, egregious examples like hamburger for steak aren’t likely to exist in general. The effect of substitution is real, however, even though it probably doesn’t affect the CPI estimates to anywhere near the extent estimated by Shadowstats or other hostile analysts.

Recently, technology has given us the tools to examine in real time what prices are doing. The best example of this is MIT’s Billion Prices Project, which we will touch on in part 5 of this series. But first, in part 4, we’ll focus on the remaining significant criticism of the CPI, that of how housing costs are handled.

Subscribe via E-mail

Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®