The Sordid Truth About Inflation

With PPI out today, and CPI out tomorrow, inflation will be on Trader’s minds. Now is as good a time as any to update our thinking on Inflation.

Its been quite a while since we last railed against the absurdity of inflation ex-inflation — the reporting of only items that don’t go up in price to determine price increases. Given the Bank of England’s surprise rate hike last week, we thought today was as good a day as any to update this issue.

For those of you relatively new to the Big Picture, here’s our story so far: When the Fed slashed rates to half century lows, they jump started a flatlined economy. First, we reflated, then we inflated. With the cost of capital (i.e., borrowing money) so cheap, demand for anything dollar denominated lifted off. This sent prices for oil, gold, real estate, industrial metals, etc. skyrocketing. 

Politicians hate to make it appear that growth is merely price increases, so the US government has an inherent bias in its data reporting — Inflation is understated and Growth is overstated. Nothing so corrupt as the data being fudged; rather, the tilt of BLS and Commerce Dept is to be "growth friendly and inflation hostile." Given how massive the COLA payments based on BLS CPI are, its almost understandable.

All economic models in their attempt to depict reality have a slant, and our official models massage the data: They seasonally adjust them, account for hedonic improvements, create new modifications. The problem with this is that as time goes by, the cumulative impact of this is to create a disconnect between the model and reality. Like a small error in the initial trajectory of a rocket launch, a few million miles later and you are way off course.

The long term impact of this bias is to make the official inflation data more and more fictionalized. This forces economists to put themselves thru circus-worthy contortions to rationalize the disconnect. A classic example: Rising oil prices are not considered inflationary, but falling oil prices are somehow disinflationary. The lack of symmetry is at best annoying, and at worst intellectually dishonest.

Back to the BoE: They have matched the Federla Reserve’s Rate of 5.25% — yet somehow, inflation in the UK is admitted as rising, yet inflation in the US is declining. As Bill King astutely points out, this is simply false: "It’s comparing apples to oranges. The UK doesn’t engage in the plethora of ‘hedonic’ adjustments that pervert US CPI, and the UK uses real home prices plus mortgage rates to determine housing inflation.”  In other words, inflation is rising in both locales, only its reported differently.

Now here’s where things get interesting: This past Monday, the Financial Times reported that the Office for National Statistics (ONS) — the British Equivalent of the BLS — published a web calculator to let consumers determine their own inflation rates, as people have accused them of doctoring the sata:

“The nation’s top statistical office is fighting back against accusations, fuelled by newspaper campaigns, that its inflation index is inaccurate and underestimates the rate of inflation experienced by most people.

The Office for National Statistics today launches a personal inflation calculator on its website so people can see for themselves how their spending pattern is likely to deviate from the average for the retail price index, the most comprehensive measure covering goods and -services bought by most households.

Jim O’Donoghue, ONS inflation statistician, said: "It is clear from correspondence received and reports in the media that many people think inflation is higher than that shown by the official figures and that this has gone some way in under-mining confidence in them."

It getsw even better: Bill King delves into the details, and finds that, despite being vastly more accurate than our own system, the Brits still underreport their inflation rate:

"One of the findings of the ONS research is that people’s perception of inflation has been skewed by higher price rises of goods they buy regularly.  [No kidding, Sherlock!]  Big ticket electrical items and  clothes have fallen in price, but since they are bought relatively rarely, the ONS believes consumers have  a false perception of rapidly rising prices…

But the ONS has recognized that some people, particularly those spending a high proportion of their incomes on services, would have a higher inflation rate in recent years.”  To quote Guinness,  Brilliant!!!…Western governments are ‘fooling’ with economic data to obfuscate lower living standards  due to the enormous transfer of wealth to Asia.  But fin traders/investors heed the data."

A classic example of how inflation is underreported showed up in (of all places) Parade magazine. They noted that the US spend smore on healthcare in both percent of GDP and absolute dollar amount than any other country on the planet.

This massive expenditure didn’t happen overnight, but has steadily built up over time. And, BLS continues to dramatically understate it: King notes that "For 12 years, the BLS has been reducing double-digit real healthcare inflation to about 4.2% per annum via hedonic adjustments. If they were honest, they should increase healthcare costs more than the actual gains due to negative hedonic adjustments for the deteriorating healthcare results."

We noted a few weks ago in Wage Surge? that the actual annual increase in health care costs has been well north of 10%. Indeed, Tuesday’s WSJ had an article that detailed

"Increasing numbers of Americans are encountering similar choices as employers ask them to buy their own benefits, including disability and life-insurance policies, medical and dental coverage, and even benefits not normally found in the workplace like homeowner insurance and identity-theft coverage. Few businesses are actually replacing employer-paid benefits with these so-called voluntary benefits — "voluntary" because you pay for them yourself. But some experts predict that eventually, American workers will have to buy many of the benefits they now get free at work, much the way most of the burden of funding retirement savings has shifted from employers to employees in recent years."

Paying for something that was previously part of your compensation package? Pick your poison: Either that’s wage and income deflation, or price inflation.

Our curmudgeonly bottom line: Though decellerating somewhat, Inflation remains a genuine issue, and it is still considerably higher than reported. Wage gains, on the other hand, are actually worse than reported. 

Or to quote the eminent Judge Smails on the current state of data reporting: You’ll get nothing, and like it.


Calculating Inflation Rates
Personal inflation calculator & related information

Personal calculator for your own inflation rate
Scheherazade Daneshkhu,
FT, January 15 2007 02:00 | Last updated: January 15 2007 02:00

ONS to launch personal inflation calculator
Rebecca O’Connor
Times Online, January 04, 2007,,16849-2531286,00.html

Is America Still No. 1?
David Wallechinsky
Parade, January 14, 2007

The Shifting Calculus Of Workplace Benefits
Amid Rising Health Costs, Employers Offer Growing Menu of Insurance Products That You Pay for Yourself
WSJ, January 16, 2007; Page D1

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What's been said:

Discussions found on the web:
  1. Macro Man commented on Jan 17

    Before lauding the British too much, consider that despite the 60% y/y decline in natural gas prices, the “gas” component of inflation rose 40% y/y.

    Part of this is a measurement issue, and part of this is the fact that the UK (where real wages are now comfortably negative, thank you very much) suffers from a set of utility companies that are rip-off merchants to a farcical degree. Despite the fact that Feb natural gas has fallen from 85 to 30 pence per 1000 therm since July, the gas companies are raising prices again next month.


    BR: My issue is with the gov’t reporting of inflation — not the utility that’s charging the end users. If the they raise prices, and its accurately reported, then from a strictly data analysis perspective, we don’t care.

  2. JKB commented on Jan 17

    Unfortunately for the dissemblers, a good portion of the population have very good inflation estimators, a fixed income. They know nothing of the math but they know they buy mostly the same things each month and they really know whether it is easier or more difficult to purchase what they need each month. Ask someone on social security whether prices are going up or down. Cheap imports and big ticket items aren’t a big part of their monthly expenses. Food, medical, prescriptions, gasoline, electricity, and heating are. I believe you’ll find “retiree” inflation to be quite high.

  3. Guest commented on Jan 17

    Don’t forget the substitution bias that biases the price increases down. Generation low real interest rates brought to you courtesy of Maestro Greenspan and the BLS. And leave it to Bernanke to blame it on the Asians. Priceless.

  4. MarkTX commented on Jan 17

    Any chance of An “ACCURATE” USA inflation

    calculator being published by the Fed.(LOL)

    Does anyone know of some place that already has something similar on a website?

  5. Bob_in_ma commented on Jan 17

    I’ve given you grief before about some of your inflation posts. But I generally agree with you here (though I feel obliged to note that the “quite a while” since you last railed against the absurdity of “inflation ex-inflation” happens to be the period when core rates were higher than the top line rates.)

    Hedonics are clearly subjective adjustments and really amount to a subtle type of what is known as bullshit.

    There is absolutely no doubt that the average computer today is appreciably more useful than that of one in 2000. And medical advances have substantially increased survival rates for childhood diseases like leukemia.

    But then, 45 years ago when I was a baby with pneumonia, the doctor came to our house to treat me, several times. Is there an hedonics adjustment for that? A commute to work may not cost a whole lot more than it did 40 years ago, but it takes 2-3 times longer. Is there an adjustment for that? Walmart’s prices are substantially lower than the five and dime on Main Street of 1940. But isn’t there a loss for the experience?

    By my subjective judgment, the 3-4 years of life expectancy we’ve gained with a five-fold increase in healthcare costs, just isn’t worth it. And the movement to an homogenized, suburbanized world of parking lots and shopping centers has degraded life immeasureably.

  6. Michael C. commented on Jan 17

    They noted that the US spend smore on healthcare in both percent of GDP and absolute dollar amount than any other country on the planet.

    Fucking tell me about it. Our total family health insurance premiums was just adjusted upwards 23% this month. And that’s after a 10% adjustment from age a few years ago.

  7. Lauriston commented on Jan 17

    I saw this headline today: “Prices Soar for California Citrus After Temperatures Plummet; Governor Seeks Federal Aid”

    says to watch out for triple prices for oranges, lemons, avocado, vegetables etc. small fry for sure, but i can already see how this freeze is going to be good for the economy, just Katrina, high gas prices, cooling housing market, war in Iraq etc. This economy is resilient, until it is not!

  8. rdub9000 commented on Jan 17

    Great Post B.

    What do you think is going through the feds mind?

    “Man, Inflation is high – but we don’t want to put out any reports that show that…Even though it should be obvious to the hoi polloi. So let’s just lie about it and hope people don’t realize that we should be raising interest rates. Let’s see how long we can prolong the pain of this housing mess.”

    I’d rather a bandaid get ripped off quickly – it’s more painful if you pull it off slowly.

  9. Robert Coté commented on Jan 17

    How much does anyone care to wager that when th Califonia freeze spikes food prices at something like a 20% annual rate next month the Fed issues a temporary adjustment to the metric?

    Oh, and a favorite of mine. Tuition. Here in California state schools are forbidden by the State Constitution from charging tuition. No inflation there.

  10. VennData commented on Jan 17

    Computers are more powerful since 2000 but what do you actually do with it now that you didn’t then? Games have better graphics, do you play WOW? I didn’t think so. You Facebook? No. You might have watched some YouTubes but that’s it (I’d rather download and save them if they were any good… like before.)

    Personal finance, Word processor, email, video, pictures, web search etc. I did all that in 2000.

    Until someone comes up with an application Microsoft can rip off, the desktop is stagnant, not disinflationary… now, my mobile phone has picked some applications…

  11. curmudgeonly troll commented on Jan 17

    I agree with you that the rate of inflation I feel in NY doesn’t match what the Fed puts out.

    But if you bring out a new car and it has GPS and satellite radio, side airbags, a bigger engine, and the price went by $2,000, lack of hedonic adjustment would massively overstate inflation.

    Measuring inflation is hard. The factors biasing CPI upward as mentioned in the Boskin report are real. We don’t seem to be doing a great job, but a small downward bias in reported inflation is worse than an upward bias. That would give CPI-linked deals and negotiations a constant upward bias and increase inflation.

    Some discussion of the Boskin report –

  12. Fred commented on Jan 17

    I’m expecting the massive number condo’s lying fallow will be converted to rental apts, and consequently rent competition will force a massive drop in rental rates.

    If this happens, will the inflation hawks cry “fowl” (pun intended)?

  13. Estragon commented on Jan 17

    Fred – In thinking about the condo glut vis EOR/inflation issue, I’m not so sure that we’ll see things unfold as you suggest.

    1. The condo glut appears to be geographically concentrated, and may affect rental rates only in glutted locations.
    2. Rental demand may develop in lower income families, and the overbuilt condos may be priced out of their range even when discounted.
    3. Putting a new condo on the rental market has complications. It can’t be shown as effectively, possession date flexibility is impaired, there are management hassles, and in the end you’re left trying to sell a used condo.

    It may be that the glut will pressure rents down, but I don’t think it’s a done deal.

  14. Fred commented on Jan 17

    Fair points…thx

  15. Fred commented on Jan 17

    The beige book looks like a soft landing glide path to me.

  16. Macro Man commented on Jan 17

    Barry (re post #1)

    Fair point. But for a commodity like natural gas, where the purveyors do little more than hook up a line, in a manner of speaking, one would expect at least some degree of correlation between the underlying commodity and the inflation measure. In the case of natural gas and the RPI gas component in the UK, the contemporaneous correlation is -0.1 on y/y changes. Even data mining to optimize the correlation via a 12m lag, one still only sees a correlation of 0.48, which is still quite low for a commodity (you can click on my name to see a chart of this).

    For giggles, I calculated my own personal inflation using the ONS calculator. 7.2% y/y as of November- the calculator hasn’t been updated for Dec yet. Still, mustn’t grumble- it’s still better than the 12.6% inflation I evidently experienced at the beginning of 2005.

    I don’t think it is inarguable that inflation measures (at least those targeted by central banks) should include mortgage costs. In the UK, for example, 99% of the mortgages are floating rate, with many (including mine) pegged to the official Bank of England base rate. In most cases, mortgages are roughly 30-40% of expenditure. So if inflation is too high, and the central bank hikes rates to combat it…they end up putting up inflation via raising mortgage payments. This could in extremis create the perverse situation where a BOE facing too-high inflation (should they target the RPI, which they do not) would cut rates to mechanistically ease inflation pressures via lower mortgage payments.

  17. rob cyran commented on Jan 17


    New houses are typically built on the high end (or at least that used to be the case) you then get a shuffle as the richest move into new houses, the middle class move into the vacated upper-end homes and the poor move into vacated middle-class homes.

    Lots of exceptions of course, but I think the general pattern holds – as long as their isn’t a switch away from owning into rental housing.

    Anyway, this seems to imply that prices come down on the high end, and then everybody starts to move

  18. anderl commented on Jan 17

    I take offense to your cause and effect for CB monetary policy and its effect on inflation. When the Fed cuts rates they are sending a signal to banking institutions that future rates will be lower. Its the expectation of lower rates that causes banks to stop lending or tighten their own belts. The result is a dry up of liquidity. The banks have already seen demand weaken for borrowing in the markets and have probably reported this to the Fed so there real isn’t a chicken or egg situation here.

    Inflation doesn’t start until the expectation for increasing rates appears. When the Fed was at 1% the expectation was for them to do a BOJ negative rate policy and send the economy into a Japanese depression. It wasn’t until rates were flat for some time and then finally… when the Fed raised rates and started on a policy of measured paces did Commercial paper borrowing went through the roof. This effect was because the market expectation was the money would be more expensive in the future and it would be better to lock in cheap money now then to pay for it later.

    So what do you do with all the extra cash at low rates. Well us it like you would have used it. Since rates would be higher in the future use it to lock in future production and resources now. So massive borrowing led to massive run up on material prices. Most hedges were in the 3-5 year time frame.

    Take it for what it is worth.

  19. lewis commented on Jan 18

    The gummint could be misleading us on inflation? Dang nab it, does that mean we also might not be winning the war in Iraq? And yes, I see a seasonal adjustment being required for fruit prices…..”Lies, damn lies, and government statistics.”

    But seriously, the bigger question raised is the credibility of most government statistics – unemployment, gdp, just about any of them. I think they are all fudged, but in the US there is a limit to their fudging, because they can’t lose complete credibility, otherwise the whole system falls apart. So what you are talking about is, oh, the 25% or so that they can and have played with. But give them credit, they play with it with such technical modifications (OER, for heavens sake) that its pretty easy to get away with what they do.

  20. Max commented on Jan 18

    I think hedonistic adjustments are necessary for the correct estimation of inflation, but on the other hand, I simply cannot imagine how does BLS manage to adjust its way out of the obvious inflation in healthcare and education? I cannot belive that the healthcare we receive now is that much better than was a few years ago – if anything, it’s gotten worse. And yet, the premiums go up constantly.

  21. oldprof commented on Jan 19

    Barry has made his usual eloquent statement of the typical Wall Street view of government and data. Since no one from the Fed or the BLS will stop by to comment, I have tried to explain how they look at the problem. Readers who do not have closed minds on the subject might want to take a look.

  22. A Dash of Insight commented on Jan 19

    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 gang, bulls and bears alike, can agree. Doug Kass, Barry Ritholtz, Ed Stavetski,

  23. Blissex commented on Jan 21

    «I think hedonistic adjustments are necessary for the correct estimation of inflation,»

    Well, that depends on what you want to measure: prices or value? Is a price index about nominal prices or value relative to price? Does it measure what you spend or what you experience?

    The dishonest apologists of the real asset owning inflation party have turned nominal price indexes into an easily manipulatable index of subjective experiences.

    The absurdity of this is pretty obvious: suppose that $15,000 today were to buy car that is three times better than a $5,000 car in the 1980s, then there has been no inflation of the price/value ratio even if the price has tripled, so ”no inflation”.

    But that is a joke, as you cannot buy today for $5,000 a 1980 car if you feel that would suit you, you have to pay $15,000 so it is pointless to compare the value now and then.

  24. cm commented on Jan 21

    Blissex: One other example is laptop computers. They are undoubtedly cheaper today than in 2000.

    But, in 2000 I bought a laptop with a 650 MHz processor and 192 MB memory. Under high load but rarely during “regular” operation, the fan would come on, but make very tolerable noise. Some time ago I bought a successor model with a 1+ GHz processor (if memory serves) and also more memory, where the fan kicks in very often and generates a much higher-pitched and less tolerable noise.

    Now to the point of my story — the successor model has a button above the keyboard for limiting processor speed to about 650 MHz, and fan operation and noise are reduced to something resembling the previous level.

    Where’s the progress there please? The second laptop was undoubtedly cheaper and nominally delivers higher performance, but is it really better when you have to dumb down performance to restore silence? Aside from subtler points that more recent processors also get somewhat more performance at the same clock rate.

    If I’m not mistaken, the rationale for hedonic adjustment of computers is that newer computers enable more “productivity”. I have yet to see that.

    Many other so-called “quality improvements” go along similar lines.

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