The Controversy Over Inflation: Is There More Than We Are Aware Of?

Mr. Kauffman is an independent Certified Financial Planner practicing for over 25 years.

How can it be that with gas prices flirting with $4 per gallon and with food prices on the rise, there only is a 3.2% annual Consumer Price Index increase through April 2011? Does there seem to be a disconnect to you?

If your answer is yes, you are not alone. Despite repeated reassurances by Ben Bernanke, Chairman of the Federal Reserve Bank, that inflation is well in hand, a growing number of notable economists have been questioning how accurately the CPI actually tracks the true rise in the very same consumer goods and services that we use every day.

To fully appreciate the controversy, it may be valuable to step back and take this in context.  The Bureau of labour Statistics of the U.S. Department of labour is charged with tracking changes in the prices of 207 consumption items (e.g. raw materials, as well as goods and services) at the manufacturer, wholesale and retail levels in 44 geographical areas.  The result is 9,108 components which at times behave similarly and at other times differently.  The technical issues imposed are daunting to say the least.  While the methodology used for this tracking can be critical, it is inevitably the local retail price level that most impacts consumers at the grocery store, gas pump, restaurant, etc.  (http://www.house.gov/jec/fed/inflat/cpi-2.htm)

The official monthly “All Urban” CPI for the past year can be found at http://www.bls.gov/news.release/pdf/cpi.pdf). You may recall just a year ago and coming off the 08-09 financial crisis, the big concern was actually “deflation.”  That occurs when prices decline and is perhaps the scariest of all scenarios Deflation was a dominant factor in extending the Great Depression of the 1930’s.  When consumers believe that prices are falling, they are less likely to spend money and to do the activities they normally do.  The economic results can be disastrous.

So Bernanke, as a devote student of the Great Depression, has been working in earnest with his Federal Reserve colleagues to actually create modest inflation.  And he has been claiming reasonable success in those efforts.

That said, there is a growing number of leading economists and academics who have been questioning the ability of the government’s CPI to accurately track the true costs of goods and services on which we spend money on every day to live, work, and entertain ourselves.   One noted economist, John Williams, has gone so far as to routinely refer to the CPI as a “bogus index.”  The Dartmouth trained economist believes that the Bureau of labour Statistics has, under the auspices of “improvement,” actually changed the calculation method “24 times since 1978” and that if the same methodology were being used today, the true CPI figures would be more like 10%! (see http://bsfootprint.com/economics-economy/shocka-inflation-is-much-higher-than-government-distorted-metrics-indicate).

One methodology change in particular, called “the substitution effect” (as recommended by the Boskin commission report under the Bush 1 and Clinton administrations, in the 1990’s: see http://www.house.gov/jec/fed/inflat/cpi-2.htm) is often cited as an overt example of CPI understatement.  Underlying this process is the presumption that when prices for goods and services rise, consumers will tend to “substitute like products to avoid the price increases.”  As example when the price of steak rises, it is assumed that even the most devoted consumer will choose to buy hamburger instead.  Whether that behavioural change actually occurs and to what extent is the subject of great controversy.  Critics claim that this one change in and of itself could be understating the true inflationary pattern by 1-2 per cent annually.  The argument continues that when you filter in all the other methodology changes, some minor and others major, the end result is a dramatically understated CPI.

What possible incentive would there be to understate such a critical economic indicator?  Because the CPI is the key inflation index used to adjust social security, military retirement, and numerous other entitlement programs.  It is also the basis for our income tax system, including tax brackets, personal exemptions and the standard deduction.  Bottom line, the Boskin Commission estimated that over $600 billion would be saved if the CPI increases could be reduced by 1.1% annually for the 10 year period 1997-2006.  So supporters of this theory are confident that motivation abounds.

Conspiracy theories aside, “Product Downsizing” may be another way that inflation is subtly affecting us.  Therein, items particularly in the food category are finding their packages contain less product offered at the same price.  The NY Times (http://www.nytimes.com/2011/03/29/business/29shrink.html?_r=1&ref=business) recently suggested an idea called “Stealth Inflation.”  Manufacturers are seeing the costs of their commodities rise in the face of an otherwise tight fisted economy where frugal shoppers abound.  Rather than pass prices on and risk losing market share to a cheaper competitor, the slightly smaller package allows manufacturers to pass on rising prices in a discrete manner less likely to incur customer wrath.  So for example, when a two ounce candy bar suddenly appears on the shelves one day as 1.8 ounces but continues to sell for the same price, the change could be construed as an 11 per cent price increase. 

As John T. Gourville, Harvard Business School marketing professor, so aptly put it: “Consumers are generally more sensitive to changes in prices than to changes in quantity.” So Gourville suggests that subtle changes in package design or inclusion of more air to fill the package, can give the same shelf appearance.  But the reality is, less in hand for the same price equals higher cost.  And that spells inflation in any language.

How these practices specifically affect us may be the fuel for much economic controversy.  When translated into our future planning, at the very least it can serve to place more emphasis on the need for growth in savings among investors of all ages.

There is common agreement, especially with our increased longevity; over one in four of us may be facing 30 years or more of retirement (according to the Society of Actuaries Annuity 2000 Mortality Table).  Should inflation average 5% per year, it will take $200 in just 7 years to buy what $100 buys today.  Considering the number one fear of retirees today is running out of money, achieving financial independence in our golden years is vital. Suffice to say, it is absolutely imperative that techniques geared toward capital and purchasing power preservation be an essential part of every retirement portfolio.

This information is not considered a recommendation to buy or sell any investment. 

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