Understanding Inflation Data

There is probably no single piece of data that is less respected and more misunderstood than inflation reports.  It is the one subject where the entire Street.com gang, bulls and bears alike, can agree.  Doug Kass, Barry Ritholtz, Ed Stavetski, and Cody Willard have all disparaged government efforts to measure increases in the cost of living.  There is even a website where a guy with an econ degree from a top school (meaning he should know better) spends a lot of words creating a conspiracy theory about this number.  Maybe he has a different agenda.  They also have strong support from Bill Gross.

I promised eighteen months ago (so many issues, so little time) to explore this topic.  It is too complicated for a short post, but let me try to cover the basics — a review of the accepted wisdom on the Street, some obvious points they have missed, and a couple of examples showing why the reasoning is wrong.

Street Wisdom

The basic thesis is that the government spends millions on data that is worthless and biased.  Some believe that the measures are a conspiracy of some sort, designed to make the economy look better than it is.  Some think that the current Administration “cooks the books” somehow.  Others just think the government is incompetent.

In general, the sole support of such theories consists of the assertion that reported numbers do not correspond to the experience and observations of those pontificating on this subject.  Thoughtful readers may choose whether this “evidence” is persuasive.

Government and Inflation

Let’s consider some facts about the history of inflation calculations and the plausibility of the Street wisdom.

• The easiest idea to dismiss is the conspiracy notion.  Governments are very poor at doing conspiracies.  There are too many people to keep secrets about “cooking the books.”  A good way to make a mistake is to use one’s experience in watching action movies to form an impression of how government works.  A good way to avoid mistakes would be to take some courses in Poli Sci, like the ones I taught at Wisconsin.
• The Federal government does not have a consistent interest in understating inflation.  Key observers view government as some unitary actor, trying to serve some specific interest.  The idea is that “all politicians want to exaggerate growth.”  The mistake here is something that social scientists refer to as a kind of “reification.”  Anyone studying government soon learns that this method does not take one far.
• The government loses revenue through overstating inflation.  This is because many elements of the tax code are indexed.  I was heavily involved in this analysis and decision process at the state level in the 70’s.  No one on the Street mentions this point.
• The measurement of inflation is vitally important to powerful interest groups who benefit from a larger inflation adjustment, including labor and senior citizens.  It is a politically charged topic, with no clear bias for those in power.
• The party out of power does not share a bias in making the economy look good.  Anyone following the 2004 election process should know this.

So the Street position about a unitary government actor, with a bias, does not survive even cursory examination.

Pundits would benefit by studying the history of inflation adjustments.

• The Stigler Commission analyzed how inflation was measured in 1961, leading to improvements in government methods.  Many of those were not adopted at the time, but the research was better.
• The Boskin Commission looked carefully at the evidence and found that inflation measures actually over-stated price increases.  This was a bi-partisan group, headed by a Republican expert, listening to testimony and evidence from many experts.  Most of the adjustments that Street pundits now criticize were the result of their findings.
• The Fed believes that the CPI still overstates inflation, choosing the PCE measure instead.

At “A Dash” we like to look for the real experts on a topic.  On one side, we have a bunch of smart guys using a seat-of-the-pants model of government and a “martini index.”  On the other side we have multiple studies by serious economists.  They are just as smart as the Wall Street types.  The difference is that they have devoted entire careers to getting this right.  Some of them work in government, attempting to improve these measures and employ them effectively.

Why Does the CPI Seem so Wrong?

Inflation is the price change in a fixed market basket of goods and services.  When individuals look at the resulting measures, their personal experience raises questions.  There are several reasons for this.

• Confusing a service with the result of a service.  The biggest example is health care.  As a business owner I am well aware of the rising costs of health insurance. A lot of my time is actually dedicated to making sure that I compare qantas health insurance premiums and other health insurance policies to ensure that I get the best health insurance coverage for me and my business.  The problem is that what health insurance buys changes all of the time!  It now buys all sorts of tests, studies, and drugs that did not exist a few years ago.  Many of us (including the Old Prof) are alive because of treatments that would not have been available had we suffered the same illness ten years earlier.  The fixed market basket would have us buying the old services — but then we would be dead.

• Ignoring quality improvements.  The car you drive now is much safer than the one you would have bought thirty years ago.  It has better brakes, bumpers, steering, and air bags, just to get started.  It also lasts a lot longer.  You cannot buy a car that is the equivalent of the old model, because no one sells anything that bad.  If your car lasts twice as long, and provides better fuel consumption and more safety, it has more value than the old model.  Once you realize that products change quality, the question is not whether to make some adjustment, but how to make that adjustment.  One can quibble about how the adjustments are made, but if a pundit wants to go there, it calls for a lot more expertise on the subject than the critics exhibit.

Here is my first car (one has to imagine it completely black, so my brother called it the Batmobile).

• Housing.  People have chosen to buy larger houses with more features.  They view homes as investments as well as a place to live.  This is a serious measurement problem.  Once again, it is not a question of whether the adjustment is necessary, but the best way to do it.

• Personal market baskets differ.  To create an overall national measure the government conducts a survey of what urban consumers buy.  Any individual consumer will have a different result.  Wall Street types have a different life style.  Senior citizens have different needs.  It is a difficult measurement problem.  A lot of people spend careers trying to do this right.

Conclusion

The Street view of inflation is an example of (unintended) arrogance, a subject we have discussed before.  Anyone who thinks that he/she knows more about this from putting a wet finger in the air than the experts know after years of study is seriously wrong.

Can investors profit from this common Street mistake?  Perhaps.  Those offering this comment seem to think that policymakers will somehow recognize the error of their ways, or that the economy will falter because of this poor measure.  It is all part of the Cycle of Negativity.