The High Price Of Understated Inflation
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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