Is Inflation Understated?

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Submitted by Shane Obata-Marusic (@sobata416),

It’s ironic that in a day and age where Keynesian economics is the “accepted view” we still don’t pay enough attention to what Keynes said about inflation.

"By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some... Those to whom the system brings windfalls,...become "profiteers," who are the object of the hatred... the process of wealth-getting degenerates into a gamble and a lottery... Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

Keynes On Inflation

The problem today is that some people believe inflation is lower than it actually is.

The Consumer Price Index CPI is used to measure the cost of maintaining a certain standard of living. Now it measures the cost of maintaining a certain level of satisfaction.


In reality, the purchasing power of the consumer dollar is tanking and the prices of many goods, services, and assets are increasing in price. The end result is that the consumer is suffering. By creating incredible amounts of money, the central banks of the world are debasing the currencies that they issue. In other words, the value of all of existing dollars is reduced when new dollars are supplied.

This is translating to a lower quality of life for more Americans. When one examines real median household income – which was down to $51 ,000 in 201 2 from $56,000 in the year 2000 – this becomes evident.

Before we continue, let’s make something clear. The year over year rate of increase in inflation has been in a downtrend for some time. Therefore, it’s reasonable to conclude that disinflation is a real risk.

That said, because of the presence of the central banks, it’s unlikely that deflation will become a real problem.

The CPI affects the economy because cost of living adjustments to social security, federal civilian and military retirement, and supplemental security income are tied to it. It’s also used to index income tax parameters, TIPS, and some federal contracts.

If the CPI is so important then why does it understate inflation?

That question brings us to the government’s “inflation dilemma”. The US government has 1 of 2 choices: either it can 1 ) mislead its citizens by understating inflation or 2) release accurate inflation data thereby increasing social benefit obligations. This is a lose-lose situation because, unfortunately, both choices only serve to perpetuate an already insurmountable debt problem.

So why is it important to know that inflation is understated? Because, as Keynes said in the opening quote, inflation is essentially a means by which wealth – in the form of real assets such as real estate, businesses, stocks, and bonds - is transferred from the poor and the middle class to the rich. As asset prices inflate, the rich get richer. This allows them to purchase even more assets. At the same time, the poor and middle class become worse off because they have fewer assets and more debt.

Due to the fact that the CPI understates actual inflation, low and middle income individuals are struggling to keep up with the rising costs of living. As a result, more and more people are relying on the government for support.

Inflation is only “low” because of how it’s calculated. Since the 1980s, the US government has made many changes to how the CPI is calculated. These changes have resulted in an index that no longer accurately represents how expensive it is for people to live.

The Way The Politicians Wanted It


In the early-1990’s, political Washington moved to change the nature of the CPI. The contention was that the CPI overstated inflation (it did not allow substitution of less-expensive hamburger for more-expensive steak). Both sides of the aisle and the financial media touted the benefits of a “more-accurate” CPI, one that would allow the substitution of goods and services.


The plan was to reduce the cost of living adjustments for government payments to Social Security recipients, etc. The cuts in reported inflation were an effort to reduce the federal deficit without anyone in Congress having to do the politically impossible: to vote against Social Security. The inflation-calculation changes had the further benefit to government fiscal conditions of pushing taxpayers artificially in to the higher tax brackets, thus increasing tax revenues. The changes afoot were publicized, albeit under the cover of academic theories. Few in the public paid any attention.


Federal Reserve Chairman Alan Greenspan and Michael Boskin, then chairman of the Council of Economic Advisors, were very clear as to how changing or “correcting” the CPI calculations would help to reduce the deficit. As described at the time by Robert Hershey of the New York Times, “Speaker Newt Gringrich, Republican of Georgia, suggested this week that fixing the [CPI] index, with its implications for lower spending [Social Security, etc.] and higher revenue [tax bracket adjustments], would provide maneuvering room for budget negotiators...”


John Williams'
Shadow Governement Statistics

The Boskin Commission estimates that the cumulative effects of a 1% bias (to the upside) would have added 1 trillion dollars to national debt in between 1997-2008; clearly, this was an incentive to lower the reported state of inflation.


If the CPI understates inflation then why is it so widely used and referred to? Probably because it’s accepted as “the best measure of inflation that exists”.

In terms of measurement, the CPI has 3 main problems: 1 ) hedonics, 2) substitution, and 3) understated costs.

1 ) Hedonic Adjustments are meant to account for changes in the quality of goods and services. The concept of adjusting prices for changes in quality makes sense. That said, the process is too subjective and is far from perfect.

Some examples:

New computer features 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.


John Williams'
Shadow Governement Statistics

More issues related to subjectivity:

  • where does a good stop being a variety of a given product class and become a product on its own? – ex: Toyota corollas and Toyota camrys.
  • when it comes to a good or service’s characteristics, who’s judging their utility? The consumer or the producer or both?
  • how can someone accurately determine the “quality” of novel or intangible items?
  • what if the ratio of prices does not = the ratio of qualities?


  1. if an old product is discounted and a new product is introduced at an unusually high price
  2. if an item is introduced into the market at an unreasonably low price in order to induce demand and then subsequently increases in price during a return to normal market conditions
  3. when a new item is not comparable to an old item

and one final comment on inflation:

The take away point here is not that hedonics is a bad concept but that a lot of subjectivity is involved in calculating hedonic adjustments. I t’s a conflict of interest for the Bureau of Labor Statistics (BLS) to calculate the CPI because it’s in the government’s interest to lower social benefit payments. As a result, the BLS’s inflation data are questionable.

2) Substitution may reflect changes in consumption patterns. That said, the concept of substitution invalidates the CPI as a measure of the cost to maintain a certain standard of living. Ex: if Bob eats steak every day for a year but is then forced to switch to chicken because of rising beef costs then it’s plausible to think he’s maintained the same level of utility. That said, one cannot argue that he’s maintained the same standard of living if he’s forced to substitute steak for a lesser alternative.

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: On-going 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.

3) If the BLS was actually trying to measure the cost of home ownership then their measure of housing inflation – the Owner’s Equivalent Rent (OER) – would include property taxes, maintenance costs, and insurance. The next best option would be to use the actual price of home. The OER is even less realistic as it measures “how much someone’s house would rent for monthly, unfurnished and without utilities.

“the problem with this hypothetical approach to measuring a significant portion ofCPI is obvious at best. At worst, it’s somewhat disturbing in today’s information age where actual home price data are readily-available at the mere stroke of a key. The “corrected” CPI measure clearly failed to predict an incredible amount of home price inflation which ultimately led to the biggest housing bubble in the history of the world.”

A lower OER leads to a lower CPI . This in turn leads to lower rates which lead to an even lower rate of growth in OER; it’s a negative feedback loop. What’s more is that the OER is the single largest component of the CPI"

The CPI also fails to reflect higher costs in other areas such as energy, tuition, medical care, and food and beverages. Here is a chart that demonstrates how the CPI underestimates inflation:

Lastly, it’s important to the note that the CPI doesn’t include taxes - which have grown from 5% in 1 91 3 to over 30% in 201 3. I t doesn’t make sense that the CPI doesn’t include such a significant expense. Thus, the CPI is flawed as a measure of maintaining a certain standard of living.


The following section will examine multiple alternative measures of inflation. I t is not that any or all of these measures are perfect, it’s that the actual rate of inflation is higher than the CPI says it is. As a reminder, at its current levels, the CPI indicates that inflation is running at around 1% year over year.

1 ) Shadow Stats:

According to Shadow Stats, the CPI understates inflation by around 3% and 7% for the 1990s and 1980s based shadow stats alternatives respectively.

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 above 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.

2) Chapwood index:

In 2012, the average inflation rate for the top 30 cities – ranked by population – was approximately 11% - or more than 3x higher than what the CPI was.

3) The EPI (Every day Price Index):

As you can see in the following chart, the CPI and EPI tracked relatively closely until the early 2000s. At that point in time, the 2 measures began to diverge. Since 1 987, the EPI and CPI have increased by approximately 1 40 and 1 1 0 percent respectively. In other words, the EPI suggests that cumulative inflation from 1 987 to the present is 30% higher than the CPI would suggest.


Inflation is higher than the CPI says that it is and most people are aware of that. I f you ask your friends and family whether or not they’ve noticed a general increase in prices then they’ll say yes. As noted above, both food and beverages and energy costs have risen in price dramatically. Why is that important? Because the majority of people are exposed to one or both of those costs on a regular basis.

You can argue the magnitude of the inflation understatement but you can’t argue that the official numbers are accurate.

Under reporting inflation has led to many predictable outcomes.

Americans are accumulating debt, reducing their spending, relying on government transfers, and searching for yield because the cost of living is going up.

A repressed CPI also has many effects on the financial markets.
1) It provides justification for artificially low interest rates and QE
2) It leads to the perception that the USD is holding its value and
3) It leads to overstated real returns in stocks and especially bonds

In conclusion, inflation is the means and a wealth transfer from poor and the middle class
to the rich is the end.

Don’t be fooled by people who claim that there’s no inflation.

Although disinflation is – at present – a real risk, cumulative inflation is still drastically reducing the consumer’s purchasing power.


Source: Triggers (via @sobata416)