The reported rate of inflation is a lie
I’ve been reading and learning about the Consumer Price Index (CPI), otherwise known in layman’s terms as the ‘rate of inflation.’ The CPI is calculated by the Bureau of Labor Statistics (BLS) and is reported periodically (monthly is the most common number quoted). The original idea of the CPI was to periodically collect the prices for a basket of consumer goods in order to gain information on price increases or decreases. So far so good.
What I’m learning, however, is that the CPI grossly understates actual consumer prices. To understand why, you have to known a little more about how CPI is calculated. Bear with me, this’ll get good.
Here are the components of the CPI:
Notice the three largest pieces of the pie: housing, transportation, and food. Here’s where it gets good. Let’s take a look at housing for evidence of how the CPI understates inflation.
How CPI underestimates the cost of housing
Within the housing category are three subcategories - shelter, fuel and utilities, furnishings. Within the shelter subcategory is our bogey - owners’ equivalent rent.
Every month, BLS polls 50,000 landlords and tenants to come up with owners’ equivalent rent. But because of the recent housing bubble, rents nationwide have been suppressed as more people could ‘afford’ a home and bought one. This caused a glut of unoccupied rental units and hence kept a lid on rents. That’s why people like Flexo at Consumerism Commentary are now comparing the wisdom of renting versus buying.
We know from government census data that the homeownership rate as of 2005, the most recent data available, stood at 68.9% That means 31% of the U.S. population rents. So when the CPI is calculated, 23.4% of the entire number is derived from 31% of the population’s situation. The increased cost of housing for 69% of the U.S. population is ignored. According to the OFHEO (the government agency charged with tracking these things), for 4Q2006 home prices were 5.9% higher than a year earlier. That’s after three years of price appreciation in the teens.
After looking at the situation in this light, I believe the CPI understates actual inflation to a surprising degree. Why would the feds publish this lower inflation number? Oh, I can think of a couple of reasons…
- Lower COLAs for military and other government workers
- Smaller COLAs for Social Security recipients
- Lower payments for Treasury Inflation Protected Securities (TIPS) and similar bonds
- Tax brackets are adjusted more slowly, increasing tax revenue
May 16th, 2007 at 9:13 am
Thanks for the explanation. I was reading in the paper today how the market shot up yesterday due to lower than expected inflation rates. I guess now I know why!
May 17th, 2007 at 9:24 am
[…] Advanced Personal Finance thinks the Consumer Price Index grossly understates actual consumer prices. […]
May 18th, 2007 at 1:59 pm
[…] The reported rate of inflation is a lie I’ve been reading and learning about the Consumer Price Index (CPI), otherwise known in layman’s terms as the ‘rate of inflation.’ The CPI is calculated by the Bureau of Labor Statistics (BLS) and is reported periodically (monthly is the most common number quoted). The original idea of the CPI was to periodically collect the prices for a basket of consumer goods in order to gain information on price increases or decreases. […]
May 20th, 2007 at 9:21 am
“The increased cost of housing for 69% of the U.S. population is ignored.”
I think your approach overestimates inflation for a lot of people. Me, for example. I already own a home. I’m not moving. Increases in “owners’ equivalent rent” mean nothing to be because my mortgage payment doesn’t go up. To the extent the CPI increases due to “owners’ equivalent rent” it overstates the inflation to which I, and anyone not in the market for another house, am subject.
May 29th, 2007 at 9:30 am
[…] currently writes about the topic at advancedpersonalfinance.com. Check out his post titled “The Reported Rate of Inflation is a Lie“. (Feed link to Advanced Personal […]
June 1st, 2007 at 9:32 am
[…] See why I think the reported rate of inflation is a lie? […]
June 1st, 2007 at 10:14 pm
I’m with Mark–renters feel the increase continuously, whereas only a subset (1/7th if moving the avg of every 7 years) of owners feel it. And on average, they benefit at the same rate. So I’m not convinced CPI is as bad as you say.
See http://www.bls.gov/cpi/cpifaq.htm#Question_3 for “Whose buying habits does the CPI reflect?”
June 5th, 2007 at 7:15 am
[…] of how accurately you think the U.S. government reports on inflation (I think the reported rate of inflation is a lie and I hate the so-called ‘core’ CPI), everyone can agree on one thing - it’s […]
June 9th, 2007 at 6:37 am
[…] final example is a biggie. The CPI assumes that everyone in America rents. [See my post The Reported Rate of Inflation Is a Lie for a detailed explanation] As I’m sure you are aware, over the last few years home prices […]
May 18th, 2008 at 5:01 pm