2008 CPI and Inflation and Analysis

The inflation so far for 2008:

Southeast = [ ( 203.501 – 203.457 ) / 203.457 ] * 100 = 0.022%
National = [ ( 210.228 – 210.036 ) / 210.036 ] * 100 = 0.091%

Great, right? Not so fast…

I don’t want to start spouting doom and gloom but there are caveats to such flat growth.

Inaccurate CPI Data
In 1995 the government very discretely changed how the CPI is calculated. The basic concept is that the old style of gathering CPI data looked at the basic cost of goods in a consumer “basket”. This means that the cost of bread, electricity, housing, etc., is compared over time to see what the differences are. Prior to 1995 this was a one to one comparison – a loaf of rye bread was compared with a loaf of rye bread. However, with the changes in 1995, the government is now taking substitutions into account. The basic idea is that if the cost of a loaf of rye bread goes too high consumers will shift preferences and buy a loaf of white bread instead. Because of this, the shift does not accurately take into account the true inflation. This is easily explained in an example.

In January 2008 a loaf of white bread is $2.25 and a loaf of rye bread is $2.42. In February 2008 the same loaf of white bread has jumped to $3.14 and the same loaf of rye bread has jumped to $3.89. The government, specifically the Bureau of Labor Statistics (BLS), takes a look at this and decides that people are unlikely to pay a 38% price increase for the loaf of rye bread and decide to use a cheaper substitute, the loaf of white bread, feeling that it is a more accurate depiction of consumer behavior. Despite the fact that both white bread and rye bread suffered a large increase, the BLS only records a jump of 23%, the difference between the 1/08 price of rye bread and the 2/08 price of white bread. In the old system of CPI calculations they would have recorded a 37% increase, the difference between the 1/08 and 2/08 price of rye bread. This means that the BLS has just artificially lowered rye bread inflation by 14%.

Another stunning example of this is that the BLS chose, in 1983, to stop paying attention to the price of home ownership and instead focus on rental prices. This means that while the price of homes were artificially inflating, they were not being factored into the CPI, which is the primary means by which The Fed monitors the economy and takes adjusting actions, such as lowering or raising interest rates. In addition, the average rental prices “actually declined by a few points”, according to Dollars & Sense magazine. This means that while home prices skyrocketed the decreasing prices in rental properties caused the CPI to artificially drop.

This is clearly inaccurate and leads to artificially low numbers. John Williams, of Newsweek, estimates that today’s CPI figures could be under by around 7%. This means that, if measured accurately, the actual inflation for 2008 COULD be as high as 7.022% for the Southeast and 7.091% nationally. If we suddenly find ourselves in a state of deflation, we now have no way of knowing whether we are actually in a deflationary period or if government tinkering has skewed our view of the data and is shielding the fact that we are actually inflating.

Impending Deflation
Let’s say we ignore the inaccuracies in the CPI we just went through. We are good now, right? Maybe.

What is concerning is NOT that we are very, very close to an equilibrium state but that the annual trend just happened to put us at this equalibrium by the end of 2008. The year started off with inflation rising, which it continued to do until around June, when it started tapering off. Since June it is been constantly dropping, to the point where we have arrived back at our coveted equalibrium state of near zero. The problem with this is that if the trend continues we will very soon find ourselves in a state of deflation, which historically leads to rampant production cuts, job loss, and opens the door further for a depression. What we really want and need is small but steady inflation – somewhere between 1-3. But who knows, with the way the BLS is reporting CPI data, maybe we have actually been inflating this entire time.