The Misleading Consumer Price Index

Investors are trying to figure out why the Fed continues to raise interest rates. The most important job of the Fed is to contain inflation. That is what they target their actions to. Why then, with the most recent CPI index coming in flat year-over-year, does Greenspan and Co. continue to boost short-term rates?

This contradiction could very well be explained by many folks’ distrust of the government’s reporting of the CPI statistics. A flat CPI index seems strange given that prices for many goods and services are rising at a very fast rate, squeezing lower and middle class workers.

Let’s take a closer look at the components of the CPI index. The largest are housing (42%), transportation (17%), food (15%), and medical care (6%). These four categories of goods and services account for 80% of the consumer price index, which is showing flat to slight increases in recent months.

Does anyone see anything suspicious about this? Real estate is seeing its biggest boom ever. Oil prices are at 20-year highs on an inflation-adjusted basis. Commodity prices are rising substantially, impacting food costs. Healthcare costs have been rising at double digit rates for years now.

Are these facts being accurately recognized in the government’s CPI data? I, along with many others, would argue no. And perhaps Chairman Greenspan and the FOMC feel the same way, causing them to raise the Fed Funds rate higher than some think is warranted.

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7 Thoughts on “The Misleading Consumer Price Index

  1. Gotti on July 19, 2005 at 8:16 AM said:

    Some interesting comments about how the CPI is calculated, especially the housing component.

  2. Chad Brand on July 19, 2005 at 8:22 AM said:

    Thanks for the link. Indeed, a very detailed explanation for why the CPI gets a lot more attention that it deserves…

  3. SiamTwin on July 19, 2005 at 8:36 AM said:

    Indeed, Jim Grant has calculated that CPI would be around 5% rather than 3.5% if you recalculate it using housing prices instead of imaginary rental equivalents (which is the way it was done prior to the early 1980s, when the Bureau of Labor Statistics adopted the present, convoluted measurement).

  4. A Federal Reserve Bank employee has an excellent post on this over at macroblog:

  5. Chad Brand on July 19, 2005 at 1:50 PM said:

    I would take issue will a couple things from that post:

    “The rental equivalence approach is the “right” approach because it measures the cost of owning a home to a homeowner. What is the cost of owning a home to someone who already owns a home? Well, it’s the opportunity cost of living in your home rather than renting it out.”

    I simply disagree with this. The cost of owning your home equals the sum of your mortgage payment, your homeowners insurance, your property taxes, and any other expenses you incur to live in that house. Most people do not have their homes paid for completely and incur those costs to live in their home every year.

    “If you are already a homeowner (without appealing to opportunity costs), you have NO cost-of-living rise as home prices rise.”

    Again, this is incorrect. Your property taxes are based on your home’s value. We’ve heard numerous accounts of people forced to sell their houses because they can no longer afford their annual property tax bills, which in expensive markets can amount to tens of thousands of dollars per year.

  6. Mr. Brand

    Before using the rental equivalence, the BLS used the “user cost” approach which incorporated interest, depreciation, taxes etc. payments as you cited. However the CPI has to be a fixed market basket of goods. THe fluctuations in interest rates made the CPI (at least from the economists view point) even more inaccurate.

    Now, do I think that the CPI is a great indicator of inflation? Not at all, but I think that including asset appreciation, like home prices, into the inflation measures will result in an even greater inaccuracy.

  7. Chad Brand on July 19, 2005 at 5:30 PM said:

    Incorporating appreciation in the prices of homes is no different than incorporating appreciation in the prices of energy or food staples, or anything else.

    I agree that interest rates would make the housing component very volatile, but interest rates need not be included in the calculation. You can use the national median home price just like you would quote a barrel of oil, or a bushel of corn.

    I don’t see how that would be MORE inaccurate than the current housing component of the CPI, which is showing 0%-2% annual increases despite record high home prices and utility costs for natural gas and electricity.

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