Many investors are worried about inflation and, as a result, are considering buying inflation indexed bonds and other inflation protected investment vehicles. They may be setting themselves up for significant losses, however, because of the way the government is now calculating the CPI, and the further changes being proposed. In the opinion of this writer, the CPI calculation appears to be inaccurate and, as a result, such investments may not be appropriate inflation hedges. [Let me explain.] Words: 1533
So says Avery Goodman in an article* which Lorimer Wilson, editor of www.munKNEE.com (It’s all about Money!), has further edited ([ ]), abridged (…) and reformatted below for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Goodman goes on to say:
Treasury Inflation-Protected Securities (TIPS) [and referred to as Real Return Bonds (RRBs) in Canada], for example, are marketable securities whose principal is adjusted by changes in the Consumer Price Index (CPI). With inflation (a rise in the index), the principal increases. With a deflation (a drop in the index), the principal decreases. That means that the interest rate remains fixed, but the actual money paid out increases or decreases depending on how the rate of inflation has affected the adjusted principal.
The official CPI is calculated by the Bureau of Labor Statistics division of the U.S. Commerce Department and, unfortunately, is at odds with the perception by much of the public that prices are rising very quickly. The most recent Commerce Department CPI release claims the general rate of consumer inflation is running at about 3.6% year over year. Meanwhile, many people report that their personal experience is that prices are up, year over year, by considerably more. [In fact, this] disconnect between official numbers, and public perception may become more severe [as] new legislation is being introduced in Congress which, if passed, will cause the inflation rate, as computed by the government, to drop for various reasons.
Controversial CPI Statistical Methods
For now, let us discuss the two most important and controversial statistical methods used by the Bureau of Labor Statistics that many people complain is adversely affecting the accuracy of the CPI. These are known as “hedonic quality adjustment” and “product substitution weighting.” The two techniques profoundly affect calculation of the Consumer Price Index.
a) Hedonic quality adjustment
Hedonic quality adjustment means that government statisticians reduce the price of various goods that they later plug into the inflation calculation in order to account for product improvements. To understand this concept, let’s use a theoretical example. Let’s say, the Chevrolet Malibu is a part of a basket of goods used, in 2010, to create the official CPI. GM introduces a 2011 model that has a quieter engine, a redesigned suspension, and more foam padding on the dashboard. The base model car cost an average of $18,500 in 2010. In 2011, people pay an average of $19,600 because the manufacturer’s suggested retail price goes up. The Commerce Department does not use the $19,600 number. Instead, it considers how much the improvements are worth. That is called the “hedonic value” of the changes. Let’s say that the government concludes that the improvements are “worth” a “hedonic” $2,000. The statisticians plug $17,600 into their formula as the cost of a Chevrolet Malibu, not $19,600.
b) Product substitution weighting
Product substitution is another method used by government statisticians. The CPI, if calculated as a fixed-weighted index, overstates changes in the cost-of-living because consumers can substitute toward categories of goods and services whose relative prices have fallen. Government statisticians say that the basket of goods must be dynamically changed to account for the changes in behavior. Let’s say, for example, that fillet mignon is part of the CPI basket of goods in 2010, when its price per pound is $13. Then, by the end of 2011, fillet mignon skyrockets to $25 per lb. The government statisticians conclude that people will eat more hamburger because it has become relatively cheaper in relation to fillet mignon than it was the year before. So, according to the government, the true cost of living must include a heavier weighting of hamburger meat rather than fillet mignon. This is because that is what people are buying in 2011. The statisticians plug $3 per pound in place of $25 per pound into the CPI calculation.
The Original CPI Calculations
The calculation of the CPI inflation rate did not always include these techniques. Back in the 1970s and early 1980s, a fixed basket of goods was used, throughout administrations headed by both Republicans and Democrats. During the 1970s, America experienced what many economists now refer to as the Great Inflation. The CPI soared to the double digits using the government’s then-traditional static basket of goods. That was all changed in 1982, when a more dynamic formula, including these new statistical techniques, began to be introduced. Yet, if we apply the 1980s formula to the period immediately prior to the World Financial Crisis of 2008, we would find that the CPI was soaring into the mid-double digits, according to economist John Williams. Instead, with new hedonics and product substitution formulas, the government claimed that inflation was in the low single digits.
What Formula Changes to CPI Will Mean
More formula changes are on the horizon. Vice President Joseph Biden heads a budget cutting committee, and the committee says it has a plan to reduce government expenses by a $220 billion, over ten years, by making the CPI calculation “more accurate.” Savings will be achieved on Social Security cost of living increases, Medicare reimbursements, TIPs interest servicing expense, and a host of other government expenses tied to inflation. All are indexed to the official CPI, and all these expenses will go more slowly if the reported level of the consumer price index does down.
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The… new proposals will help the CPI reflect “how people change their spending patterns when prices increase” …[and] require the BLS to consider the fact that people use less of things that rise quickly in price. For example, let’s say people shift to buying very small fuel efficient cars because they cannot afford the price of gasoline. People are forced to use a lesser volume and weight of gasoline and the government argues that, as a result, the overall inflation rate has gone down. If and when this new legislation becomes law, the BLS will dynamically change the CPI formula to change the weighting of various goods and services, reducing the percentage assigned to goods that rise in price, and increasing the percentage assigned to goods that fall or are static.
Does this make sense? Is hedonic and/or product substitution a correct and accurate way to figure out what the price increases in the economy are? If, for example, the population can’t afford good cuts of beef anymore, and must substitute bad cuts, can it be said that the cost of living is not rising, or has gone down? As to proposed changes to the CPI, is it accurate to claim that consumers are not experiencing inflation simply because the price of gasoline is forcing them to use less and they are buying smaller cars in order to do so?
CPI and Inflation Protected Securities
The CPI profoundly affects buyers of “inflation protected” securities. It affects both the sum you are paid when your TIPS bond matures and the amount of interest that a TIPS pays you every six months. That is because interest payments and the periodic adjustment to principle are based upon the rate of inflation, as calculated by the US. Commerce Department. The inflation rate is not calculated by the intuitive formula that existed prior to 1982, which may be the method by which a lot of people perceive inflation rates around them. If the CPI is inaccurately understating the rate of inflation investors will lose both part of the principal and part of the interest they were supposed to receive…
So-called “I bonds,” sold many years ago, had a substantial base interest rate of up to 3% that helped to partially offset the possible inaccuracy of the current CPI calculation formula. New I-bonds, however, don’t carry this benefit. Most supposedly inflation protected investments are devoid of a substantial base rate [and,] because of that, they are no longer a wise place to invest funds.
If you are seeking protection against inflation, you are better served by investing in precious metals or commodities…[which will] likely take a substantial dip when, and if, the Fed really stops printing money [making it] an excellent time to buy [them] as many hedge funds and other fast-money types exit the field…
- Real-time Inflation Data is Now Available – Finally https://www.munknee.com/2011/06/real-time-inflation-data-is-now-available-finally/
- These Indicators Say Inflation to Go to 4% Soon – and 6% by 2014 https://www.munknee.com/2011/06/these-indicators-say-inflation-to-go-to-4-soon-and-6-by-2014/
- What Inflation? Take a Look At All the Deflation Around You! https://www.munknee.com/2011/05/what-inflation-take-a-look-at-all-the-deflation-around-you/
- Inflation Coming? Treasury Market Says Otherwise! https://www.munknee.com/2011/05/inflation-coming-treasury-market-says-otherwise/
- Official and ShadowStats Monthly Inflation Rates: 1872 to Present https://www.munknee.com/2011/03/official-and-shadowstats-monthly-inflation-rates-1872-to-present/
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above.