Why calculating the pace of price growth is so complex
The inflation rate is measured multiple ways, and critics say it is artificially low
WASHINGTON — When it comes to inflation, the price might not always be right, and that has consequences for the nation’s economy and the pocketbooks of average Americans.
The pace at which prices are rising — known as the inflation rate — is crucial to important policy decisions, such as setting the poverty threshold used for food stamps and other government assistance.
In recent years, inflation has been sluggish as the economy has recovered from the Great Recession. It’s the reason why Social Security recipients are expected to find out this week they’ll get only a tiny cost-of-living increase next year.
And the slow price growth, consistently below the Federal Reserve’s annual 2% target, has been a major factor in the decision by central bank policymakers to keep their benchmark short-term interest rate near an unprecedented rock-bottom level.
But calculating inflation is complicated. And the figures produced by federal statisticians don’t always reflect what many Americans experience when they make everyday purchases.
“It’s inherently an imprecise thing,” said Laurence Ball, an inflation expert and head of the economics department at Johns Hopkins University. “Different people consume different baskets of goods, so my personal inf lation rate and your personal inflation rate could be different.”
But some Fed critics say U.S. officials are understating inflation to justify the continued economic stimulus of low interest rates, which reduces the federal government’s borrowing costs on the national debt.
The failure to respond to inflation that is higher than government estimates threatens to overheat the economy, risks a dangerous bubble in stocks and other assets and could lead to big price increases in the future, those critics said.
“If the government is in charge of measuring inflation and the government benefits when the inflation number is low … it stands to reason they’re going to come up with a way to show that inflation is low,” said Peter Schiff, chief executive of investment firm Euro Pacific Capital. “Would you believe the Mafia if they came out with a crime study that showed there wasn’t a lot of crime?”
He and others have been warning of a huge inflation surge since the Fed lowered its benchmark interest rate to near zero in late 2008. Those predictions have yet to materialize. But Schiff isn’t alone in believing federal officials might be cooking the books.
About 44% of Americans either completely or somewhat distrust the economic data reported by the federal government, according to poll results released Thursday by the public radio show Marketplace and Edison Research.
Critics say the formula for calculating the Labor Department’s widely used consumer price index has been altered in recent decades to create an artificially low inflation rate.
The methodology received an overhaul in the late 1990s. But that was after the Senate-appointed Advisory Commission to Study the Consumer Price Index, headed by economist Michael Boskin, determined that the index overstated annual inflation by 1.1 percentage points.
Gauging inflation correctly is important.
Too little inflation can hinder the economy by stunting the growth of worker salaries and business profits, a problem that has plagued Japan for years. Too much inflation, as the U.S. experienced in the late 1970s and early 1980s, can also slow economic growth by making goods and services too costly while diminishing the value of savings accounts, bonds and other assets.
“What we’re trying to do is measure price changes as accurately as possible,” said Steve Reed, a staff economist at the Labor Department’s Bureau of Labor Statistics, which produces the consumer price index. “We certainly don’t have an agenda beyond that.”
The bureau tracks the prices of 80,000 items, including groceries, gasoline, healthcare and rent, determines their relative importance to the average household and produces two national, four regional and 10 metropolitan-area consumer price indexes every month.
But figuring out the actual inflation rate is even more complex.
The Fed uses a different measure produced by the Commerce Department’s Bureau of Economic Analysis that is based on Americans’ personal consumption expenditures.
Both statistics base their calculations on a basket of goods and services purchased by an average household.
But the Labor and Commerce departments don’t fill their baskets with all the same items, and assign different weights to their importance in a household’s monthly purchases.
The Labor Department bases its calculations on a survey of households and makes changes to the basket every two years. The Commerce Department surveys businesses and alters its formula more frequently in response to price changes.
The Commerce Department also assumes people will make more changes to their buying habits based on price shifts.
“If the price of beef goes up, you might shift to chicken,” David Shulman, senior economist at the UCLA Anderson Forecast, said of the Commerce Department’s price index. “It allows for dynamic substitution. The CPI doesn’t allow for that.”
In addition, a key and rising household expenditure — healthcare — is calculated differently.
The Labor Department considers only what consumers pay out of their own pockets, while the Commerce Department includes healthcare costs paid on their behalf by employers and the government.
The Commerce Department measure tends to show lower inflation than the consumer price index. The difference is more pronounced when you look at core inflation, which excludes often-volatile food and energy prices.
For the 12 months that ended Aug. 31, the core consumer price index increased 2.3%, while the personal consumption expenditures price index was up just 1.7%.
But there isn’t even agreement within the Federal Reserve System about the best way to calculate inflation: the Dallas and Cleveland regional Fed banks each produce their own alternative measures, as do some private organizations.
David Stockman, who was White House budget director under President Reagan, created an alternative consumer price index, which gives more weight to food, energy, housing and medical costs than the Labor Department’s figure. According to Stockman’s calculations, annual inflation has been running at about 3% since 2000, much higher than what the Labor Department index shows.
Because inflation is factored into the government’s calculation of economic output, the higher rate means growth has been even slower than reported, he said. And that helps explain the economic anxiety being expressed in the presidential campaign, said Stockman, who just released a book on that subject titled, “Trumped! A Nation on the Brink of Ruin... And How to Bring It Back.”
“People don’t believe what Washington and Wall Street are telling them about how great the economy is,” he said.
But Ball, the Johns Hopkins professor, and most mainstream economists believe federal statisticians do a good job of calculating inflation.
“Compared to a lot of things the government does, there’s a pretty big consensus they do it well,” Ball said.
Still, the complexities of calculating an average inflation rate for the whole nation mean that, just as with the gas consumption of a new car, the mileage of your dollars may vary.
Where you live is a major factor.
The consumer price index for the Los Angeles metropolitan area showed more inflation than in the nation as a whole for the 12 months that ended Aug. 31, the most recent data available.
The L.A. index increased 1.4%, the Labor Department said. Excluding food and energy, core prices were up 3.3% — a full percentage point higher than the national core rate.
To understand how inflation can vary, look at a key expense for many Americans — housing rents.
The Labor Department calculates and weighs rents in part by asking homeowners in a survey how much they think they could get a month if they rented their property.
Real estate firm Zillow uses its database of rental and home listings to make its own calculations.
“There’s no guesswork on our end,” said Svenja Gudell, Zillow’s chief economist. “It’s purely based on models and actual listing data.”
Those approaches can produce significantly different results.
In the case of the L.A. market, Zillow’s rent index increase of 4.7% for the 12 months that ended Aug. 31 is in line with the Labor Department’s 4.6% rent increase for the region for the same period. But in the Seattle metropolitan area, Zillow’s 9.7% increase in rents for that period was well above the Labor Department’s 6% figure.
Psychology also affects how people view inflation, economists said, which could be a factor in distrust of the official numbers.
“People think of the sticker shock when prices go up, but they don’t think of it when they go down,” Shulman said. “You notice gasoline prices much more going up than going down.”
The UCLA Anderson Forecast has been expecting inflation to rise above the Fed’s target as an improving job market has boosted wages, Shulman said. Although the Fed forecasts that core inflation won’t be above 2% until at least 2020, he thinks it will happen next year.
“We’ve been arguing there’s more inflation pressure out there than what the Fed thinks,” he said. “That’s been wrong, but it’s moving in our direction.”