The High Price Of Understated Inflation

Tyler Durden's picture

The reliable data which policymakers and the public need if effective solutions are to be found is not available. As Tullett Prebon's Tim Morgan notes, economic data has been subjected to incremental distortion; Data distortion can be divided into two categories. Economic data has been undermined by decades of methodological change which have distorted the statistics to the point where no really accurate data is available for the critical metrics of inflation, growth, output, unemployment or debt. Fiscal data, meanwhile, obscures the true scale of government obligations. While he does not believe that the debauching of US official data is the result of any grand conspiracy to mislead the American people; he does see it as an incremental process which has taken place over more than four decades. From 'owner equivalent rent" to 'hedonics', few series have been distorted more than published numbers for inflation, and few if any economic measures are of comparable importance; and the ramifications of understated inflation are huge.

Via Dr. Tim Morgan, Tullet Prebon, the high price of understated inflation

Though the undermining of data quality has been widespread, few series have been distorted more than published numbers for inflation, and few if any economic measures are of comparable importance. In the United States, CPI-U inflation reported at 3.2% in 2011 probably masked real price escalation which was very much higher than that. This is hugely significant, because inflation is central to calculations of economic growth, wages, pensions and benefits. Moreover, understated inflation undermines calculations of the ‘real’ cost of credit as represented by interest rates and bond yields, a factor which, as we shall see, may have played a very significant role in the escalation of indebtedness during the credit super-cycle.

British inflation data, too, seems pretty optimistic Between 2001 and 2011, average weekly wages increased by 38%, which ought to have been a more than adequate rise when set against official CPI (consumer price index) inflation of 27% over the same period (fig. 4.1). But the reported rate of overall inflation between those years seems strangely at odds with dramatic increases in the costs of essentials such as petrol (+59%), water charges (+63%), electricity (+97%) and gas (+168%).

Those who question the accuracy of official inflation measures in Britain have nothing much more upon which to base their suspicions than intuition, experience and the known escalation of the prices of essentials. In the United States, this situation is quite different, and far greater data transparency has enabled analysts to reverse out the methodological changes of the last three decades. The scale of the distortions which have been identified is truly shocking.

The biggest single undermining of official inflation data results from the application of “hedonic adjustment”. The aim of hedonic adjustment is to capture improvements in product quality. The introduction of, say, a better quality screen might lead the Bureau of Labor Statistics (BLS) to deem the price of a television to have fallen even though the price ticket in the shop has remained the same, or has risen. The improvement in the quality of the product is equivalent, BLS statisticians argue, to a reduction in price, because the customer is getting more for his or her money.


A big problem with hedonic adjustment is that it breaks the link between inflation indices and the actual (in-the-shop) prices of the measured goods. Another is that hedonic adjustment is subjective, and seems to incorporate only improvements in product quality, not offsetting deteriorations. A new telephone might, for example, offer improved functionality (a hedonic positive), but it might also have a shorter life (a hedonic negative) and, critics claim, the official statisticians are all too likely to incorporate the former whilst ignoring the latter. The failure to incorporate hedonic negatives may be particularly pertinent where home-produced goods are replaced by imports, a process which has been ongoing for more than two decades. A Chinese-made airbrush might be a great deal cheaper than one made in America, but is the lower quality of the imported item factored in to the equation?

A second area of adjustment to inflation concerns ‘substitution’. If the price of steak rises appreciably, ‘substitution’ assumes that the customer will purchase, say, chicken instead. As with hedonic adjustment, the use of substitution not only breaks the link with actual prices (a process exacerbated by ‘geometric weighting’), but it also, as Chris Martenson explains, means that CPI has ceased to measure the cost of living but quantifies “the cost of survival” instead.


Geometric weighting, too, plays a significant role in the distortion of American inflation data. In any case, some of the weightings used in the official indices look strange, one example being medical care, which accounted for 16% of consumer spending in 2011 but is weighted at just 7.1% in the CPI-U.

Since the process of adjustment began in the early 1980s, the officially-reported CPI-U number has diverged ever further from the underlying figure calculated on the traditional methodology. Fig. 4.2 gives an approximate idea of quite how distorted US inflation data seems to have become over three decades. Instead of the 3.2% number reported for 2011, for example real inflation was probably at least 7%. Worse still, the official numbers probably understate the sharp pick-up in inflation which America has been experiencing. A realistic appreciation of the inflationary threat would be almost certain to have forced very significant changes in monetary policy.

Taken in aggregate, the extent to which the loss of dollar purchasing power has been understated is almost certainly enormous. Between 1985 and 2011, official data shows that the dollar lost 53% of its value, but the decrease in purchasing power might stand at more like 75% on the basis of underlying data stripped of hedonics, substitution and geometric weighting.

The ramifications of understated inflation are huge. First, of course, and since pay deals often relate to reported CPI, wage rises for millions of Americans have been much smaller than they otherwise would have been. Small wonder, then, that millions of Americans feel much poorer than official figures tell them is the case. By the same token, those Americans in receipt of index-related pensions and benefits, too, have seen the real value of their incomes decline as a result of the severe (and cumulative) understatement of inflation.


This process, of course, has saved the government vast sums in benefit payments. Rebasing payments for the understatement of inflation since the early 1980s suggests that the Social Security system alone would have imploded many years ago had payments matched underlying rather than reported inflation. In other words, the use of ‘real’ inflation data would have overwhelmed the federal budget completely or, conversely, might have forced government to come clean on what levels of welfare spending really can be afforded.

Another implication of distorted inflation, an implication that may have played a hugely important role in the creation of America’s debt bubble, is that real interest rates may have been negative ever since the late 1990s (fig. 4.3). Taking 2003 as an example, average nominal bond rates12 of 4.0% equated to a real rate of 1.7% after the deduction of official CPI-U inflation (2.3%), but were almost certainly heavily negative in real terms if adjustment is made on the basis of underlying inflation instead.

Logically, it makes perfect sense to borrow if the cost of borrowing is lower than the rate of inflation. Whilst most Americans may not have been aware of the way in which inflation numbers had been subjected to incremental distortion, their everyday experience may very well have led them to act on an intuitive understanding that borrowing was cheap. We believe that distorted inflation data may, together with irresponsible interest rate policies and woefully lax regulation, have been a major contributor to the reckless wave of borrowing which so distorted the US economy in the decade prior to the financial crisis.

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tooriskytoinvest's picture

Currency War Between The US, China, Japan In Process, Euro Could Be Next To Join The War. WGC Confirms The Chinese Are Going To Back The Yuan With Gold!!


JackT's picture

But but but but they all say they only want 2%

yrbmegr's picture

Not if they're going to fight a currency war.

The Axe's picture

One tenet that Tyler and ZH  has always proclaimed is that AAPL was the overweight issue..related to the SP rise....(one) reason   yet AAPL   has come from 715 to 460  and YET   the SP  is close to all time highs.....BULLSHIT on you TYLER!!!   you others...take ownership>>> bitch

NoDebt's picture

It's roughly a 35% drop peak-to-trough.  If it's 25% of the S&P weighting that equates to about an 8.75% hit to the index.  Which, yes, has been more than made up for by the other 75% of the index over that time.


clara-to-market's picture

I still think deflation will rule the day.

One of these European countries--Spain, Italy, Greece--will eventually return to their own currency.

Then we'll have another massive deflationary event.

yrbmegr's picture

Wouldn't it be in-flationary if one of those countries left the euro?  Suddenly now you have a flood of drachmas pouring in.

sessinpo's picture



Those drachmas or any other local currency will still have to be priced in relationship to the euro or whatever denominating currency is in play (to pay debts).

What you would need is a nation leaving the Euro, to declare bankruptcy, thus wiping out their debts.


Let me put it to this way. Say you had $1 million in greek debt. What I mean by that is you are the debtor, not the creditor. And all of a suddent Greece left the Euro and went to a local currency, the drachma.

Well, in the international markets, the value of the drachma would be such that you would still owe that $1 million in debt. You see, even though your nation left the Euro, your creditors in the Eurozone will demand payment in Euros. Thus, the value of the drachma will reflect that (it will be of lower value. You might have to raise $10 million drachmas to equal that $1 million in Euros as an example). Do not think that there will be an even par $1 dollar drachma = $1 dollar Euro. In fact, it will cost you even more because there will be a minute conversion cost for YOU to convert your drachmas to Euros to pay the debt (Another way bankers skim the market).


So thus while you think you have an inflationary environment, all the drachmas printed are being sucked up (disappearing) in the conversion to Euros.


The concept is happening worldwide in respect to the US dollar. Consider all that has been printed, yet we don't see hyperinflation. That is a hidden market message that most are missing. All the massive printing is being absorbed by massive debts and not circulation throughout the US economy. If any thing, the massive printing is propping up a few markets.

sessinpo's picture

So, as a Chinese citizen (which I am not), why would I hold gold if the fiat currency is backed by gold?


If I had (were allowed to hold) a pound of gold, what would I do? I would sell my gold for Yuan. After all, the yuan is backed by gold so it is sound, just as good, right?


So I present this logical situation (because it applies to the US also), as to what will happen to the price of gold. You would have people selling their gold (downward pressure on gold prices) to get yuan that is just as good because it is backed by gold


Now I await your logical response to this discussion and hopefully you won't debase the discussion to personal attacks and insults like most liberals on ZH do when they can't debate the facts or logic.

Ctrl_P's picture

Cheaper Chinese Kool-Aid?

Why not? They have done it with everything else.

freedogger's picture

I don't regret passing on full time employment with benefits, startups with promise of options,  jobs with a pension etc in favour of contract at my hourly rate. Pay me exactly what value I have provided at a reasonable time after it was delivered. Anything else is a ripp off in my opinion. 

MeelionDollerBogus's picture

You got it. Benefits that may be denied with fees that you pay anyhow into that from each pay (I do) and if there's a pension (none for me) you have to wait for it, and it can't pay if the pension fund is insolvent, and if by now the answer to that one is a mystery one is either very new to Zerohedge or Max Fischer / MDB.

SoCalBusted's picture

As a hedge, I am doing both.

pods's picture

It ain't that tough. The government wanted (needed) debt to be increased after the dot com collapse.

That led to low rates.  When that was exhausted and started to collapse, the government stepped in and expanded debt.

It is the same thing that every fractionally reserved debt backed currency faces.  Exponential needs in a finite world.

The punchline of this piece confused me. I thought EVERYONE knew that one?

Everyone runs analyses on the "why" our system collapsed.

Easy.  Because it has to.  

It is no more complicated than that.  



Cognitive Dissonance's picture

"Everyone runs analyses on the "why" our system collapsed. Easy.  Because it has to."

If I might add to your simple explanation.

And why do they distort the statistics to such a degree? Easy! Because they can......and because they must in order to hide the decade's long ongoing systemic crumble. They know that as soon as Wile E Coyote (the public) looks down at his "real" reality (and sees nothing but statistical air) and begins to fully recognize the proximity of his peril, the world as we know it comes crumbling down.

The only support under Wile E Coyote is our wavering faith and belief in the system and the lack of a publically accepted alternative to defect to.

OutLookingIn's picture


Hence bread and circuses for the masses.

Official stats are junk. Whereas calculate the old way. Truthfully!

Shizzmoney's picture

Everyone runs analyses on the "why" our system collapsed.

It hasn't collapsed fully, yet.  That's the big ruse about TARP, the government bailouts, the's the equivalent of duck taping the bumper on the broken vehicle that is the banking system (and the economy attached to it).

The windows are taped up, the bumper is held together by strings, and the brakes don't fully work.  But the people THINK they are driving in luxury due to the fact that the tires still work and the inside is nice (but has nothing to do with the long term performance of the vehicle).

Sooner or later, not only do we swerve off the road......we launch the entire thing off a cliff into the abyss. 

zorba THE GREEK's picture

Inflation is only at 2%, unless you eat and drive a car anywhere.

yrbmegr's picture

Indeed.  Or go to the doctor.  I agree our official inflation statistics understate real inflation in the U.S.

ebworthen's picture



Most central bankers probably don't drive or shop at the grocery store (the new nobility).

Speaking of "Beyond Belief" from the chart title:

Elvis Costello and the Attractions - Beyond Belief

"History repeats the old conceits
The glib replies the same defeats
Keep your finger on important issues
With crocodile tears and a pocketful of tissues.


In a very fashionable hovel
I hang around dying to be tortured
You'll never be alone in the bone orchard
This battle with the bottle is nothing so novel"

A Lunatic's picture

The guy starts off saying there is no grand conspiracy to mislead the American people, yet concludes by showing just how beneficial it has been for the U.S. Government to LIE to it's citizens about inflation and then places the responsibility for the outcome on reckless consumer spending.........

gwar5's picture

Of course it's a conspiracy. If it weren't, half of all the bumblings and jibber jabber would be in our favor. But NOOooo.......


We're in a Depression already and there's still more big shoes to drop. Years of negative real GDP and >10% loss of GDP. Real inflation as high as 9.3% and unemployment as high as 23% by old 1980 methods, etc.  (Click on Shadowstats others have linked to, best place to go for succinct real data.)


NoDebt's picture

I don't always see eye-to-eye with you, Lunatic, but on this point there is no disagreement.  I thought it was self-evident the need to understate inflation for the government (and all other defined-benefit obligations in general).  I found the article to be nothing but printing what I've thought for years.

You're not getting poorer, we swear.  It's all in your imagination.  These aren't the droids you're looking for.

If there was ever an obvious reason to manipulate data on a long term basis (vs. the relatively benign and obvious election year stat pumping), this is it. 

I kept thinking "doesn't everyone know this already"?

pashley1411's picture

Lunatic, you are probing the fine line between "conspiracy" and "policy".   If enough politicians and their supporters conspire to enact policies to impoversion the American middle class, its no longer a conspiracy. 

And if you are too stupid to read basic economics, its not conspiracy either, its just "bad luck".

pashley1411's picture

Lunatic, you are probing the fine line between "conspiracy" and "policy".   If enough politicians and their supporters conspire to enact policies to impoversion the American middle class, its no longer a conspiracy. 

And if you are too stupid to read basic economics, its not conspiracy either, its just "bad luck".

surf0766's picture

"We believe that distorted inflation data may, together with irresponsible interest rate policies and woefully lax regulation, have been a major contributor to the reckless wave of borrowing which so distorted the US economy in the decade prior to the financial crisis." 



No shit.

chump666's picture

Rally in full effect. The Mexican Narco psychos favorite bank HSBC just sent out it's China-centric PMI fudge *China HSBC manufacturing PMI rises to 24-month high. 

AUD, CAD just blasted out stops and anyone trying to short overbought housing bubble and China-will-crash currencies.  HFTs went all cocaine.

The print-fest continues...

not a twin's picture

Why does the distortion get larger every single year?  I've seen this in inflation indices

but not in the year-to-year inflation rates.  Am I missing something?

Since you mention "debauching" of fiscal data, here's another link:


duo's picture

the correlation between M2 and real "inflation" is almost 1.0.  M2 is about 4x what it was in 1985, and so is real inflation.

neutrinoman's picture

Another consequence: real growth was and is less than advertised. Related to unemployment through Okun's Law. With lower real growth, things make more sense, and it fits better with how Americans feel generally about the economy.

cynicalskeptic's picture

Real GDP was negative all through W's Presidency when you account for the real rate of inflation.  Serious manipulation of statistics has been going on since Carter - easrier to lie about things than face the voter's wrath.  BOTH parties have been paying this game.   Unemployment numbers are vastly understated as well - we're at 1932 record levels, over 23%.  The only reason you don't have lines for soup kitchens (well, you DO at Food Banks) is because of Food Stamps and long term unemployment......

CheapBastard's picture

You mean Grampa & Gramma can't live on that 0.01% COLA each year?

Uber Vandal's picture

Consumer Durables are down 5% over ten years.

We are definately in a deflationary environment.


MeelionDollerBogus's picture

holy shit, I can't eat my gold!



Getting Old Sucks's picture

While most here know how it works, this is a great post for the sheeple.  They just accept the governments figures and scratch their heads wondering what they're doing wrong.  I think the non implication of a government conspiracy leading to the reader to deduct that it is in fact, was a nice touch.  Good post Tyler. 

Shigure's picture

+1 Agreed. This is a good post. I understand about the distorted inflation figures due to hedonics, substitution etc, but this post clarified for me the wider implications of understated inflation figures. Thank you Dr Tim Morgan.

socalbeach's picture

Good article overall, but I would add to this statement in the last paragraph,

"Logically, it makes perfect sense to borrow if the cost of borrowing is lower than the rate of inflation."

It makes sense to borrow when real interest rates are negative, if you can get a return greater than the interest rate.

BooMushroom's picture

If you buy a car, or an acre, or a year's supply of wheat, you have received a better return than the interest rate. Hell, if you buy ANYTHING that you were going to buy anyway, a year sooner, you have received a better return than the interest rate.

That's what real negative interest rates means.

socalbeach's picture

I was going to edit my post to say negative real interest rates guarantees that there are some investments that will rise faster than the interest rate.   However, I would never borrow money to invest in stocks at their current valuation, since even with their dividends there's a good chance they will earn less than the 3.5% to 4% / year one would have to pay to get a home mortgage.  On the other hand, around here, the total return on income producing residential property has greatly exceeded 4% over the last 1.5 years.

A 3rd example would be gold, which has basically gone nowhere since Aug of 2011, so one would be down about 5% (nominally, even more in real dollars) if one borrowed money then at 3.5% to invest in it. In summary, negative real rates like we have now does not guarantee price rises in excess of the interest rate for everything over the short term.

madcows's picture

I disagree, sort of.  You have to assume that the item you borrowed money to purchase will give you a return on investment above inflation. Buying something, like a house or a car on credit is committing to a future payment obligation when you are expecting a negative wage growth.  In other words, you have to pay for it and you're losing ground to inflation, and your asset is depreciating in value.  That's a bad combo. 

However, if you can buy an asset that will appreciate at a greater rate than inflation, on someone else's dime, then that is a positive.  But, what assets are appreciating at a rate greater than inflation or even the borrowing rate?  Stocks, maybe, but they can only levitate for so long.  Bond yields are well below inflation or the borrowing rate. 

Face it, you can't easily get yield above the rate the banks are lending at.  That's their game.  The FED has done this on purpose.  They have tried to force people out of safe assets and into risky equities in order to spur economic growth (and to monetize the debt).

I refuse to play the game.  Why the hell would I want to borrow from the bank in order to buy a risky asset that has a higher probability of losing value than it does of keeping up with inflation?  How fucking screwed would I be if I borrowed money to buy Google or RIM stock 3 months ago?  I'd rather stock pile cash and wait for the next recession.  When assets fall in price, I'll pay cash for them, and the lenders can go F themselves.

Frankie Carbone's picture

The average American:


a. is too stupid to understand this article. (diet, flouride, television-induced gray matter decomposition?)


b. is too maleducated to grasp the simple mathematics and analytics to decipher the key points of this article. 


c. Has a childlike faith in the expertise, authority, and perceived benevolence of its government to bother with this stuff, or read this article. 


d. Who's the finalist on American Idol tonight? Is that in the article?


e. Has a grasp on sports statistics that is the envy of any Ph.D statitician but somehow is utterly incapable of comprehending the simplest of graphs and tables. What does inflation have to do with Jerry Rice's receiving records? 


Thank God for Fight Club. I'd go fucking bat-shit insane without having at least a few intelligent people to interact with. A rare breed I tell you, and I think as many as 14.37% of the remaining "smart people" in the world are all here in Fight Club. 

BooMushroom's picture

F: all of the above!

Silver, bitchez!

Stuck on Zero's picture

Quick question.  Are the salaries of our reps and POTUS tied to the official inflation rate?  They damned well ought to be, and not a cent higher.


MagicMoney's picture

Well when money printing monopolizes the money supply, and the money printer wants to make a profit by being the first buyers before price inflation hits higher, it makes sense to understate real inflation. I like how energy is considered too volatile to be measured as a inflation index, as if oil, energy in general are the one of the few things effected by supply and demand. If you look at the price of gas, and oil in a 50 year chart since 1960s, you would easily find it suspicious that oil volatility, or instability is actually trace-able to the Federal Reserve and fiat money. From the peak of inflation in 1980 from the inflationary 1970's to  2007-2008 where oil hit 140 dollars a barrel, which coincidently the housing bubble was bursting. Even in between those two major inflated price periods. Since 1971, oil prices have not been stable. If you compare pre-1971 decades of oil prices, you will find much more stable oil prices. Under a pseudo gold standard, oil prices are suspiciously far more stable. You check inflation historical charts with commodities, producer price index, gold, it tells the same story. It's no conincidence that energy prices are removed, or segregated in indexing the CPI.


The logic is simple how inflation effects oil prices. When money supply increases, there is expected for future demand to grow. Entrepreneurs need more oil to produce more goods. Of course there is the speculators. Either way, inflation creates a distortion of making things seem more scarcer than they really seem. Oil prices are senstive to inflation, because basically everything uses oil whether directly, or indirectly in the global economy. The Federal Reserve, & government have a knowing role of how they impact oil prices, this is why they conveniently segregate oil prices with the excuse that it's a naturally unstable market. When oil prices spike, politicians blame speculators, the weather, or some other event. Of course speculators simply react to inflation, that is money printing, and lowering borrowing costs that fuels greater economic activity creating a illusory boom with higher prices.


Inflation doesn't benefit the economy as a whole, it benefits the counterfeiters, AKA the government, and the first recipients of the money. CPI are purposely distorted to understate inflation, because the government believes if you put out a understated number officially, then the "psychology of inflation" can be surpressed which would in theory without it would mean even higher prices. If you believe the government CPI that inflation is low, then inflation is low in your head. If government told you the real inflation data, then you would be paniced, angry, and start bidding up prices, so politics as it is, it's a liars game, especially politics with fiat currency, there is a over-whelmingly incentive to understate inflation, while at the same time making the methodology look "scientific".

tony bonn's picture

although this article is good as far as it goes, it does not go far enough, nor does it credit john williams who pioneered the studies of miscreant and devious time series as corrupted horse manure having no value in sustained time series analysis.....

not only that, the corruption of these indices was a huge conspiracy to rob from widows and orphans and to keep wicked politicians in power....anyone who sees these modifications as benign misguided policy errors is a complete and total fucktard.....

it is time to grow up and call crap on crap.....and no i am not talking about jim cramer this time....or dick bove or any other assortment of bubble headed bleach blonds....

slightlyskeptical's picture

I have always been of the opinion that the Fed always kick starts inflation by raising rates, rather than by lowering them.  They" see inflation coming so" they raise rates and guess what - magically inflation comes. Not because of supply and demand dynamics but because due to higher interest rates everything becomes more expensive. It is all one great lie designed to fleece the people of everything little by little.

Let's print our money instead of borrowing it into existence. Let's destroy bank leverage to counteract any inflationary effects such printing may cause. Let's expand the money supply by up to 3% a year to allow for personal savings and let taxes make up the balance. So after paying off $20 t in debt at inception of this program they could then print $600 Billion to fund governement operations. We would  eliminate $750 t in annual debt interest payments.  This 1.35 T in savings would completely eliminate our annual defecit. The answers exist - people just need to want the answers.

MagicMoney's picture

You correlating two events, and conflating them as one. Once inflation is created, you can't instantly stop it. It's like a unstoppable tsunami. Raising interest rates doesn't increase prices, because there is less "money supply" to begin with, but once prices start rising, it's difficult to lower them, or stop them from rising in a timely manner. When the Fed expands the money supply, the extra money takes time for it to travel significantly into the economy. This is something that Milton Friedman was baffled by, and didn't understand, because he didn't understand interest rates impact on the economy, or prices. When Regulation Q was repealed, Friedman wondered why the time lag of extra money didn't bid prices in a predictable fashion. He found that it usually took 18-30 months, but didn't know why, for prices to be effected by increases in the money supply. The answer was interest rates. Friedman focused on price targeting to guide monetary policy, but that was switched to interest rate targeting instead.

slightlyskeptical's picture

I understand the economic theory behind inflation and money printing, but I don't think it has much merit when the country as a whole is completely devoid of a prudent  level of personal savings for many decades of time and a high percentage of its population struggles to meet basic needs. There has never been enough money in our economy to meet consumption demand plus savings, as such, supply and demand must be manipulated in order to arrive at inflation.  Perhaps if personal savings was fully funded and we had full consumption, then the current economic theory would be correct. What I am saying is that raising rates in a cash strapped world just serves to fuel the inflation rather than stop it. If they were really intent on stopping inflation in such circumstances the logical move would be to instead require banks to pull back on leverage. Both moves however, always  lead to depressions until the savings and consumption levels return to their optimal levels.