Governments across the world use a number of different inflation measures.
How credible are official inflation figures? There is a growing sense of disquiet about the accuracy and relevance of official inflation figures both in the US and the UK. The potential ramifications are serious.
In the US, the Federal Open Market Committee sets interest rates based partly on its mandate to maintain price stability. However, it gets to decide which measure of inflation to use.
In 2000 it switched from the CPI measure of inflation to the PCE measure, which rises more slowly than CPI. In 2004 it switched again, to "core" inflation, which excludes food and energy prices. Bill Gross of PIMCO commented later that year that, with petrol at $2 per gallon, "core" inflation laughably understated reality. Petrol has since doubled in price.
Hugh Johnston, CFO of Pepsico, agrees. With food up 3% and gasoline up 30% during the past year alone, he said last month that the "core" inflation rate of 1.2% over the same period simply did not reflect reality for ordinary people.
The unstoppable CPI
In the UK, the CPI measure of inflation is gradually replacing the older RPI measure. The CPI measure rises more slowly than the RPI; the difference between the two at the moment is 0.7%, with CPI annual inflation at 4.5% but RPI annual inflation at 5.2%.
This is partly because a different calculation methodology means that the average price of each item in the CPI basket can never exceed the average price for the same item in the RPI basket. Unlike the RPI measure, the CPI measure does not include housing costs, such as mortgage interest payments.
The Bank of England's target measure of inflation was changed from RPIX (RPI less mortgage costs) to CPI in 2003. Although the CPI measure includes volatile items like food and energy, the Bank of England is happy to follow the Fed's lead and disregard rising energy and commodity prices if it decides that these are temporary.
Last month the CPI measure replaced the RPI measure for social security benefits and state pensions in the UK, resulting in massive future savings to the Exchequer, with corresponding losses to welfare recipients.
The Office for National Statistics, which publishes the CPI and RPI data, now gives sole star billing to CPI figures in its monthly statistical bulletin, despite written opposition from the Royal Statistical Society.
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Inflation indexes usually track changes in the prices of a specific set of goods and services over time, so they need to account for changes in consumer preferences. This can yield strange results.
The Bureau of Labour Statistics, which calculates CPI inflation in the US, illustrates this perfectly. Imagine that a particular index includes the price of a standard cathode ray TV. Along come plasma screens and nobody buys cathode ray TVs any more. The standard plasma screen, costing $1,250, replaces the old $250 cathode ray TV in the index.
You might think that the 400% increase in price would be inflationary. Think again.
The plasma TV is much "better" than the old cathode ray predecessor, and this is factored into the figures by working out what the price of the old cathode ray TV would have been, had it included all of the great features of the new plasma TV.
This revised price is then compared to the price of the new plasma TV. Hey presto! If the old TV had all of the features of the new TV it would have been priced at $1,345.02 rather than $250, so the new plasma TV (at $1,250) is actually 7.1% less expensive.
Statisticians call this "hedonic regression". Bill Gross calls it a con.
Hedonic regression hides rising prices, but the man or woman in the street isn't fooled any more than Bill Gross.
In March 2011, the President of the New York Federal Reserve, William Dudley, faced an audience in Queens, New York. Attendees were concerned about rising food prices, so Dudley gave them the iPad: since the iPad 2 is much more powerful than the iPad 1 but costs the same price, iPad prices are actually falling; so it's not all bad.
But the iPad 2 is not cheaper than the iPad 1, food prices are going through the roof and, as someone in the audience remarked, you can't eat an iPad.
The credibility deficit
It is said that Joseph P. Kennedy pulled out of the stock market before the great crash of 1929 after receiving stock tips from a shoeshine boy. The picture of the President of the New York Fed trying to defend hedonic regression to an incredulous audience in Queens feels similarly ominous.
Official inflation figures are not supposed to reflect day-to-day experiences of ordinary consumers. But this point has never been properly communicated to the public, still less has it been accepted.
In 2008, the Office for National Statistics noted that some media reports claimed that the true cost of living was higher than that suggested by official figures, and that some media organisations had started to compile their own (less accurate) indexes which could further undermine confidence and trust in official figures. I doubt that their concerns have been allayed since then.
Earlier this month the Daily Mail claimed that, according to its own data, the prices in one major supermarket "soared" by more than 5% in only six months. Mortgage interest rates will rise as soon as the Bank of England starts to raise interest rates, but these increases will not show up in the CPI figures at all. The British public will feel them just the same.
Artificially low inflation figures allow central banks to keep interest rates lower for longer, and cash-strapped governments to reduce social security spending without overt cuts. But once the divergence between official figures and common experience reaches a certain level, the credibility of official statistics, and with it the institutions which use them, will be lost. That point is fast approaching.
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