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Inflation and Consumer Price Index Not the Same

If recent trips to the store are telling you that inflation is higher than what you read in the press, you may be right. According to Michael Kitces, editor of the financial newsletter The Kitces Report, inflation may be much higher than the modest rate the government claims.

Kitces explains that the way the government calculates the Consumer Price Index (CPI) has repeatedly changed. What previously measured the price increase in a basket of goods now measures the cost of living. The difference may seem subtle, but the impact is significant.

If a loaf of whole wheat bread costs $3.00 one year and $3.30 a year later, the price increase to the consumer is 10%. In the past, the CPI was simply calculated as the average price increase (or decrease) of the entire value of a basket of goods like clothing, gasoline, rent, and groceries.

However, in 1984 the Bureau of Labor Statistics began to modify the way it calculated the CPI. First, rather than reflect the price increase in a loaf of whole wheat bread, the BLS assumed consumers would stop buying that bread if they could substitute a less expensive item, like regular white bread or a cheaper brand. Says Kitces, “From the BLS perspective, the end result is a more accurate measure of what consumers are actually spending from year to year on goods and services to maintain their standard of living.”

Still, the original goal of the CPI, to measure price changes in goods and services, no longer applies.

Another modification made by the BLS is for adjustments in quality. For example, if the latest Blackberry smart phone cost $400 five years ago, the latest version will still cost $400 today. However, today’s latest Blackberry has far more power and better quality than those from five years ago. Thus, the BLS will contend the cost of an equivalent Blackberry has fallen and adjust the cost downward to reflect the higher quality, even though the price hasn’t changed.

These are important distinctions for us as consumers to be aware of. A simple comparison of prices for a fixed basket of goods, versus a comparison with the BLS adjustments, gives a very different perspective on inflation.

According to Shadowstats.com, using the pre-1984 model of the CPI shows price increases in goods and services averaging about 10% a year for the past decade. However, the modified CPI, which is now more a measure of the increase in the cost of living, shows an average increase of around 2%. As Kitces notes, “The CPI itself is no longer an accurate reflection of inflation, because it no longer measures a fixed basket of goods.”

This gimmickry is one reason why I am a bit gun-shy of the popular TIPS (Treasury Inflation Protected Securities) government bonds. Theoretically, the principal of a TIPS bond adjusts annually for inflation. If inflation is 5%, the principal of a $1,000 bond increases by 5% to $1,050. Yet TIPS bonds are not really tied to price inflation, but rather to the increase in the cost of living.

This raises a crucial question. If the borrower (the US government) is the sole determiner of the index that establishes its interest rate, isn’t that a huge conflict of interest? Certainly, the CPI modifications have substantially lowered the cost of borrowing to the US government.

The bottom line is the current inflation rate is about five times higher than the annual cost of living increase. Whether you’re making investment decisions or estimating your household budget for next year, it’s important to understand that the CPI and the rate of inflation are not the same.

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One Response to Inflation and Consumer Price Index Not the Same

  1. Financial Planner Services March 22, 2011 at 11:15 pm #

    The bottom line is the current inflation rate is about five times higher than the annual cost of living increase.