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Rise & Fall of the CPI

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The Rise & Fall
of the Consumer Price Index
© Martin A. Armstrong

It is often said that beauty lies in the eye of the beholder. Oddly enough, the same can be said of inflation. You will undoubtedly read headlines which state that inflation is under control. You will also read of analysts who continue to project lower interest rates long-term based upon their assumption that real interest rates (interest rates – inflation) are historically high. The big question which arises from a forecasting perspective is what does the future hold?

You will find effectively two camps – the deflationists and inflationists. It is important to realize that most deflationists are betting on lower interest rates ahead based upon their view that inflation is under control. What if the assumption of inflation being under control is wrong? If this view is determined relative to the CPI, should we merely accept the CPI as is without understanding its component structure?

It is widely known that our model successfully called the long-term change in trend from deflation to inflation back in July 1985. Among our most loyal long-term clients it is also widely understood that the Consumer Price Index is anything but a definitive representation of inflation. Nonetheless, although we have been highly critical of the CPI index insofar as its relative validity in terms of tracking inflation, we have dealt with this topic in-depth exclusively at our conferences, seminars and in special reports. Therefore, perhaps it is time that we address the background of the CPI in a little more detail within this report. Hopefully, this will provide a glimpse at some of the collateral material which forms an integral component of our model development at Princeton in regard to inflation.

The rise and fall of the CPI is certainly not a headline grabber as it was during the late 1960s and throughout the 1970s. The ’80s has been a era of deflation to some degree and the consequences of that trend have led to more confusion than enlightenment when it comes down to the topic of inflation.

We have discussed on numerous occasions that inflation is anything but one dimensional. The ’60s was a period known as the “wage-price” spiral because wages rose out of the shortage in skilled labor. The 70’s was known as the “price-wage” spiral because shortages in commodities and hoarding contributed to rising prices while labor fought for CPI increases. The period of 1980-1985 should have been inflationary under the classical theory that inflation is “too much money chasing too few goods.” However, even though the national debt of the U.S. doubled and money supply rose faster than a hot-air balloon. Oddly enough, inflation declined when it should have risen because increases in government expenditure were merely offset by the decrease in private expenditure. Clearly, inflation is multi-dimensional deriving its source from a variety of stimuli.

Still we find the deflationists arguing for something they do not truly comprehend while attempting to backup their forecasts based upon CPI statistics. Unfortunately, their dependency upon the CPI to support their theory of why inflation is dead is actually living proof as to why they are dead wrong. In this regard, it is the component structure of the CPI which is the best evidence as to why inflation is rising significantly in real terms setting the tone for an advance in commodities themselves of a sustained nature.

There is one saying which former President Reagan has made numerous times in explaining the U.S. and Soviet relations – “trust, but verify.” That is also our general philosophy at Princeton in regard to government statistics – trust, but verify. In those three words lies a lot of truth. Insofar as its relevance to the CPI, it simply means that we must verify all statistics and not just accept them as gospel truth.

The CPI has several major problems. The most noted is that which deals with real estate. The housing component is 39% of the total CPI. A major revision has taken place in 1983 where real estate has been largely replaced by rents. In theory, a house is an investment – not an integral part of our cost of living. Therefore, real estate is the investment while rents are more indicative of the cost in housing.

Problem number one is that philosophically this is a poor attitude facing the needs of young couples. Besides that factor, rents are controlled in many areas including New York City for that matter. Therefore, rents do not necessarily offer an clean free market indication of price trends on a national basis.

Problem number two arises from the source of the data from which this 39% housing component derives its statistical foundation. The source is the Federal Housing Administration (FHA) which imposes a maximum limitation of $60,000 on a home. This means that the housing component is essentially capped at $60,000. This may be fair for inner-city sections which are run-down or in the depressed oil regions of the South. However, this is far from realistic when considering the regions containing the greatest population density ratios.

These problems arising from the housing component within the CPI are obviously important given the 39% structure. However, we must also understand that sizable incentives exist within government to water down the CPI as much as possible. Consider that most contracts are based upon some CPI clause be it rents commercially or wage negotiations both private and public. Social Security and other entitlement programs are also tied directly to CPI increases. Therefore, if the CPI can be made to “appear” to be rising slower that reality, the net effect is a means of cutting Social Security without have to actually announce officially that cuts are being made.

The problems with the CPI do not stop there. Additional faults within the formulas exist in both quality and appearance which have contributed greatly to the long-term effect of creating a larger differential between the reality and the myth.

The “appearance” consideration within the CPI is an important issue. Items which are deemed to be appearance enhancements are ignored regardless of their impact upon price. For example, let us say that an automobile is constructed with leather seats. As the cost of production rises, those seats are replaced with vinyl. The cost of production rises further and the seats are replaced with a very cheap cloth. Had the car been produced with leather seats and those costs passed on, then the CPI would reflect a rise. But since such changes would be regarded as “appearance” and the cars still possess a seat, if such replacements enable the retail price to remain unchanged, the CPI would NOT reflect a rise because the change was only in “appearance.”

This “appearance” aspect of the CPI is largely important over the long-term. For example, a house built 30 years ago had plastered walls. Today such construction would cost at least 3 times the amount of dry walls. Housing costs are measured by the square foot without regard to the changes in appearance. This seriously affects the actual inflationary trends over the long-term by dramatically reducing the actual “true” rise in a standard value of consumer products.

Another problem which is of major concern is that of “quality” considerations. For example, when auto-pollution devices were mandated by law on all cars, those costs were born by the consumer. The average cost rose sharply adding a few hundred dollars to the price of automobiles. That was deeded to be added “quality” and therefore it is ignored by the CPI. If all cars were mandated to have a satellite tracking system and mobile telephones, and if such new devices doubled the cost of automobiles to the consumer, the CPI would reflect no change because the consumer would be receiving some new device which he had not received before and therefore it is not inflationary.

The CPI also ignored taxation which is the cost of government with the exception of some real estate taxes. But if income taxes were doubled which means that the cost of government to the consumer has doubled, taxation is deemed to be a necessary cost of everyone’s living and hence it is not included.

The list of problems goes on and on. But you can see that the CPI is far from a realistic indicator of true inflation. The government itself makes not claim in its documentation as to the validity of the CPI in reflecting the average rise in consumer prices. In regard to using the FHA data which effectively places a cap of $60,000 on housing considered in the CPI, they argue that the consistency of the data provided by the FHA justifies its use even though it may not be indicative of a large segment of the marketplace.

Therefore, the next time you hear someone say that inflation is dead, you will be able to speak on the topic with some authority. Inflation is far from dead and the only dead thing around is the brains of those who are try to deliver its eulogy.

When Secretary of the Treasury, Mr. Baker, stated that monetary policy should be guided by using a basket of currencies, most listened but they did not understand. What he could not say publicly was that the CPI is worthless as a tool to gauge monetary policy. Commodities, or the raw data without fancy formulae, seasonal adjustments or political adjustments, is the true means by which we should view inflationary trends.

When the Chairman of the Fed raised the discount rate in August of 1987 the press asked him why. He replied quite honestly – he saw a rise in inflation. Strangely enough – nobody listened. Again in August 1988 the Fed raised the discount rate and again the reply to questions was a simple statement – inflation is rising. Most thought this new Fed Chairman was inexperienced. Why was he concerned about inflation when deflation existed? Obviously, the CPI gains were marginal at best running under 5% annually. Was he being overly concerned with inflation?

The answers were perhaps too simple for most to understand. Unless the Treasury and/or the Fed directly states that the CPI is not indicative of true inflationary trends, the majority will still be looking for lower interest rates, declining commodities and rising bond markets. Consequently, the old adage comes to mind – “a little bit of knowledge is dangerous.” Indeed we all know that the CPI is the Consumer Price Index which reflects the overall inflation rate. What we do not know is how it is calculated. Hence, a little knowledge is indeed dangerous. While the majority still expect lower inflation based upon the CPI, the trends within the free markets go about their business making fools out of theory. It is not so much that theory is breaking down in economics as much as the statistics upon which such theory is based leave a lot to be desired.

So when we say that inflation is rising and will continue to do so in 1989, do not judge us by the CPI – judge us by the actions of the marketplace. The CPI will still rise in 1989, but nowhere near as much had we been including the cost of government, prices advances due to appearance, changes in real quality and a lifting of the $60,000 cap in housing data. If those thing were included, we would all quickly see that the CPI is honestly advancing nearly at nearly 10% annually right now instead of the official version of 4.5%.