Thats a real interesting thing inflation, I know financial sensus is a over the top but what they say here is true, its a fantastic read:
Washington, We Have A Problem
The caller was smart enough to know something changed and he was right. In the early 90’s the government realized it had a problem with rising entitlement costs for Social Security, Medicare, and government pensions. These entitlement payments were indexed by the inflation rate each year. With inflation on the rise it meant these costs were rising faster, thus making government deficits much worse. In order to bring the government deficits under control, it would be necessary to bring rising entitlement costs down.
One way to lower entitlements would be to bring the inflation rates down, which would translate into lower Cost of Living Adjustments (COLA). The way to do this was to bring down the rate of inflation. However, this was not done by natural means, but artificially through statistical manipulation. The supply of money and credit began to go parabolic in the 1990s as shown in the graph of M3. The rise in money and credit would mean higher inflation rates. Higher inflation rates would mean higher COLA adjustments, which would lead to bigger deficits.
The solution was to change the way inflation is measured. Media reports began to surface on how CPI was overstated. The real inflation rate was actually much lower according to government and Federal Reserve officials. The Senate Finance Committee appointed the Boskin Commission to study the problem and find a solution. The Boskin Commission published its final report ”Toward a More Accurate Measure of the Cost of Living,“ and submitted its findings to the Senate on December 4, 1996. The Boskin report recommended downward adjustments in the CPI of 1.1%. The CPI, which is used as the basis for COLAs to Social Security and government pensions, if lowered as recommended by the commission, would reduce future entitlement payments as well as impact other government programs. The CBO estimated that by overstating CPI by 1.1% it added $691 billion to the national debt by 2006. By then the annual deficit would rise anywhere from $148 billion to $200 billion annually by overstating the inflation rate. In effect the government was overpaying because the actual inflation rate was much lower.
The Boskin Commission recommended several changes to the CPI index which included:
develop and publish two indexes
abandon the fixed-weight formula for CPI goods
change the weight of items in the index from arithmetic weighting to geometric weighting
introduce substitutions in the index
seasonal adjustments to account for price increases that occur on a seasonal basis, which would smooth out the fluctuations
Reduce prices by quality improvements
The result of their implemented suggestions is the mish mash we have today, which bears no resemblance to reality. The Commissions recommendations had widespread support in the Clinton Administration, a Republican Congress and from financial luminaries such as Alan Greenspan, who was expanding the money supply at a very rapid rate as shown in the graph above.
Substitution Up until the Boskin/Greenspan initiative surfaced the CPI was computed each month using a fixed basket of goods. That changed after the Boskin Commission. The Bureau of Labor Statistics (BLS) began using substitutions in their monthly computations of the CPI. If beef prices rose, it was assumed that people substituted chicken. If chicken prices rose, then consumers would switch to fish. If all these prices rose, well consumers would become vegetarians or maybe start eating Alpo.
Weighting In addition to changing items in the index through the substitution principal the BLS also changed the weights of items in the index. Instead of straight arithmetic weightings the BLS began to use geometric weighting. The benefit of geometric weighting is that it automatically gave a lower weighting to those items in the CPI that were rising in price and higher weightings to items in the index that were falling in price.
As an example of how geometric weighting can produce lower values, a recent example from the 90’s bull market will illustrate the point through two Value Line Indexes. The indexes are essentially the same. They are made up of 1650 stocks. One index is arithmetically weighted and the other is geometrically weighted. Between January 1990 and December 2000, both indexes—which include the same stocks—produced totally different outcomes and returns. The geometric index peaked in April 1998. The arithmetic index did not reach its first peak until May 2001. The return from January 1990 to December 2000 was 52% versus over 300% for the arithmetic index. The geometric index peaked in 1998, while the arithmetic index did not reach its first peak until 2001. Since 2001 the arithmetic index has gone on to reach new a new high on 6/17/05, while the geometric index has never recovered from its peak in 1998. This is just one example how geometric weighting can produce lower outcomes not only in stock market indexes but also in inflation rates.
Hedonics The manipulation didn’t stop there. The bureau also began to adjust prices for quality. This practice became known as hedonics. Hedonics adjusts the prices of goods as a result of the increased pleasure a consumer derives from a product. A few examples will illustrate how removed the index has moved away from reality. Tim LaFleur is a commodity specialist for televisions at the BLS. In December last year he adjusted the price of a 27-inch television set for quality improvements. The 27-inch television set had a retail cost of $329.99. However, he decided the new model, which still sold for $329.99, had a better screen. After putting this improvement through the governments complex hedonic adjustment model he determined the improvement in the picture was worth at least $135! Taking in this improvement he adjusted the price of the TV by $135, concluding that the price of the TV had actually fallen by 29%! [1] The price reflected in the CPI was not the actual retail store cost of $329.99, but $194.99. The only problem for we consumers is that if we went to Best Buy or Circuit City to buy that TV, we would still pay $329.99.
Another example of hedonics at work is the way the BLS treats rising automobile prices. Mr. Reese, a specialist for autos, took a 2005 model car, which went from $17,890 in 2004 to $18,490 in 2005. After adjusting for quality items and making antilock disc brakes standard, the bureau adjusted the actual $600 price increase down by $225. The problem for we consumers is that the price of the car in dealer showrooms was still $18,490.
The Substitution Effect Substitution also plays a role in reducing the CPI. From 2001-2003 the CPI index fell by 1.6% reaching a low of 1.1%. Wall Street and the Fed were talking about the risk of deflation. Deflation was predicted everywhere in the press. The financial world became fixated over the risk of deflation even though the monetary presses were working overtime, credit was mushrooming, and asset bubbles were inflating in the mortgage, bond, and real estate markets. The reason for the decline was the substitution effect. Instead of using new car prices, which were going up each year, the BLS substituted used car prices, which were falling. In place of exploding real estate prices, the Bureau gave more weight to the price of rents, which were falling as more households bought homes. Rents were given more weight even though 69% of households own a home versus the 31% that rent.
What makes this look even more ridiculous is that in April the National Association of Realtors reported a year-over-year price increase in homes nationally of 15%.
Year Over Year Increase In Household Residential Real Estate Values ($billions)
One has to wonder as what kind of creativity will be used now that rents are starting to rise as apartment owners remove lease incentives. Perhaps the hedonic models will begin adjusting rising rents downward due to changes in the quality of amenities such as swimming pools, running water, magnificent views of the freeways, or the artistic effects of polluted air in creating colored sunsets.
Many homeowners may not be aware that as a homeowner they receive a fictional income referred to as Owner’s Equivalent Rent (OER). Essentially the BLS samples the price of rents in residential housing to come up with what a homeowner would receive hypothetically if they were to rent their own home. That sounds idiotic to me, since most homeowners would agree the family castle is in many cases a money pit and not a source of income. Unless the home is owned free and clear, most homeowners have cash outgo each month due to mortgage payments, property taxes, utilities, and repairs. As absurd as this concept appears, OER gets the largest weighting in the CPI index of 23% versus actual rent, which gets only a 6% weighting. OER is purely fictional, yet it carries the greatest weight within the CPI index.
Hedonics helps the BLS keep rising prices for goods in the CPI from ever showing up as rising prices. Even though the cost of housing, energy, food, medical bills, prescription drugs, tuition, and entertainment have soared, the government keeps reporting moderate inflation. Hedonics is partially responsible. It has become a convenient and subjective way of removing prices increases from the CPI. The combination of substitution, changing the weight of goods rising in price, hedonics and seasonal adjustments is one reason why the CPI and reported inflation has remained as subdued as it is reported each month. The problem is that these numbers are all fictional and bare no resemblance to what households face each month with their actual budgets.
