For the past few years, those who have complained that the US’s CPI systematically understates inflation have been seen as cranks. PIMCO’s Bill Gross has long agreed with this view, but now he’s getting more vocal about it. Unfortunately, if someone in the government actually listens, stock prices will likely instantly drop 10% (self-deceptionn has its benefits).
Gross’s key points from his June commentary:
Over the past quarter century, the US has made several changes to the way it calculates inflation. Each of these has reduced the amount of inflation shown in the CPI. None of them are used by any other major country. The changes include:
- “hedonic pricing” The theory here is that your new laptop is more powerful than the one you bought five years ago, so your purchasing power actually increased. This is ludicrous–the laptop you bought five years ago won’t run today’s programs.
- owner-equivalent rent. Don’t worry about the cost of houses. Just focus on what your house would cost if you rented it. Obviously understates the cost of living in eras when house prices are rising faster than rents.
- product substitution. As products get more expensive, you’ll buy cheaper ones (filet mignon vs. hamburgers), so your costs of living won’t really go up. Again, ludicrous. (More from Gross on these changes below.)
The Fed’s argument about using “core” inflation vs. “headline” inflation, meanwhile, is that “headline” is more volatile. If headline inflation had gone through extended periods in which it fell below core inflation, this might be defensible. But it hasn’t. Instead, as Gross observes, headline CPI has radically outpaced core CPI. All “core” measures, in other words, is the cost of living for those who don’t eat or drive.
Obviously, if we stop lying to ourselves about inflation, two things will happen.
First, asset prices will likely drop to account for the increased value destruction. Gross estimates that stock prices would drop 10%, and bond prices 5%.
Second, the Fed will have less room to manoeuvre, something the Depression-fearing Bernanke won’t be pleased about. In fact, an honest look at inflation could force Bernanke to start raising interest rates, regardless of what happened to the economy. After 20 years in which the Fed’s job transformed into keeping the economy growing rapidly, this won’t sit well.
But unpleasant though the reality may be, it’s time we stopped lying to ourselves. It’s hard to get busy fixing a problem until you stop denying that it exists.
The U.S. seems to differ from the rest of the world in how it computes its inflation rate in three primary ways: 1) hedonic quality adjustments, 2) calculations of housing costs via owners’ equivalent rent, and 3) geometric weighting/product substitution. The changes in all three areas have favoured lower U.S. inflation and have taken place over the past 25 years, the first occurring in 1983 with the BLS decision to modify the cost of housing. It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of the substituted owners’ equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.
In the 1990s the U.S. CPI was subjected to three additional changes that have not been adopted to the same degree (or at all) by other countries, each of which resulted in downward adjustments to our annual inflation rate. Product substitution and geometric weighting both presumed that more expensive goods and services would be used less and substituted with their less costly alternatives: more hamburger/less filet mignon when beef prices were rising, for example. In turn, hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durables. As your new model MAC or PC was going up in price by a hundred bucks or so, it was actually going down according to CPI calculations because it was twice as powerful. Hmmmmm? Bet your wallet didn’t really feel as good as the BLS did.