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A Critical View Of The Consumer Price Index

This article is in two parts:  The first set of comments is about the Consumer Price Index (CPI) by the Leuthold Group that appeared in their November, 2004 publication, “Inflation Watch” and in their publication “Accelerating Inflation And The Stock Market” which was published in July, 2004.  The second set are Legend’s® comments, which are derived from a number of sources.


 The Leuthold Group’s Comments:


 A Note About The CPI:  The Consumer Price Index (CPI) is used as the inflation gauge for this study.  For the majority of the time horizons studied, it has been a relatively accurate measure.  However, in response to historical criticism that the CPI overstates inflation, the Bureau of Labor Statistics (BLS) has worked to cushion the effects of higher prices by adjusting prices downward based on “Quality Improvement”.  The Leuthold Group believes the BLS methodology now over-adjusts for “Quality Improvements” and that the CPI currently understates inflation.


Quality adjustments are made to over one-half of CPI components to “cushion” price increases.  Example: Since 1979, the average price paid for a new car in the United States has risen from $6,847 to over $30,000, a total increase of 338% [+6.2% annually compounded (ACR)], but the CPI adjusted new car series is up only 62% (+2.0% ACR)!


The 23.4% BLS housing weight is not based on home prices, but rather on “Owners Equivalent Rent” (OER).  OER is not a good proxy when 70% of households own homes.  Over the last five years, new home prices are up 40% (+7.0% ACR), but, the BLS OER series is up only 14%!  Existing home prices are up 37% (+6.5% ACR).  This flaw may have caused the CPI to understate inflation by 1% per year over the last five years.


 Legend’s® Comments:


The Leuthold Group’s view on inflation is not a lone voice crying out.  Other well-respected legends of investing such as Bill Gross, Peter Bernstein and Jim Grant have similar views.  In fact, Mr. Gross stated in his October, 2004 Investment Outlook publication that the federal government has understated inflation by 0.5% to 1.1% each year since 1987.  Quality adjustments are a key reason he states.  By the way, in a totally unrelated coincidence, Alan Greenspan came into office in 1987.


Of more concern is the federal government’s calculation of the so-called core inflation rate which is designed to leave out two key components of the CPI – food and energy.  Even more disturbing than the fact that they have such a statistic, is their constant promotion of the core inflation rate.  The last time we looked around the country, there weren’t that many people living in unheated houses, peddling their bicycles to work, drinking water from a nearby creek and foraging through the nearby forest for food.  However, this is what it would take to leave food and energy out of an individual’s expenses.


What Does This Mean?


Obviously, by understating inflation, inflation stays lower.  Income tax brackets, which are adjusted for inflation, stay lower and tax Americans more heavily at lower levels of income, and Social Security as well as wage adjustments are held down at lower levels.


Also, an understated inflation rate means certain investment securities such as Treasury Inflation Protection Securities (TIPS) are not the rose they are touted to be, especially the ten-year bonds whose return over inflation at current prices would be wiped out by an understated inflation rate of the magnitude that Bill Gross describes.  U.S. savings bonds are also affected.


The bottom line is that understated inflation rates which are currently low are not good for anyone.  This misinformation leads everyone to make misinformed financial decisions and may jeopardize long-term planning assumptions.

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