Inflation picture

Federal Reserve Chairmain, Ben Bernanke, recently stated an explicit target of 2% inflation per year. Bernanke has a dual mandate of controlling inflation and supporting job growth. Bloomberg has an article today, which notes that many economists are skeptical of the 2% target, and are predicting higher inflation as Bernanke likely focuses on job growth over inflation concerns. ValueWalk has produced a comprehensive analysis of the metric used by the Government to track inflation; Consumer Price Index (CPI). We believe this article discusses some ideas on the subject which have never been researched.

The Consumer Price Index is as useless a measure of pricing dynamics as new jobless claims is a measure of unemployment.   Each compiles data into a broadly logical scheme, but both fall short of telling us what we need to know.

In the case of CPI, understanding variances in what consumers pay for goods and services is necessary to deriving inflation, and to exploring other concepts such as purchasing power and cost of living.  The calculation is smarter than it used to be, but are current formulas really good enough?

They might not be.   Between scrutiny of the market basket and the role of technology in changing the way companies are setting prices, it’s not clear that CPI gets us close to a useful understanding of pricing dynamics.  Yet, to let statistics with questionable relevance and accuracy influence our macroeconomy to so great a degree is to play a dangerous game with Americans’ income and world markets.

What the CPI Measures

The Bureau of Labor Statistics describes the CPI as the “product of a series of interrelated samples,” representing “all goods and services purchased for consumption by the reference population,” and “developed from detailed expenditure information provided by families and individuals on what they actually bought.”  Expenditures are classified into eight major categories: Food and Beverage, Housing, Apparel, Transportation, Medical Care, Recreation, Education, and Other Goods and Services.  Under these eight umbrellas, prices for some 200 goods are harvested.

The goods that are measured are meant to be seen as common goods and include items such as breakfast cereal, coffee, rent, mortgage payments, women’s dresses, airfare, prescription drugs, televisions, postage, college tuition, tobacco, funeral expenses, and many more.  Taxes directly related to the purchase of goods and services are included in the measure, as are government user fees, yet other taxes impacting consumer purchasing power (such as income taxes or Social Security taxes) are not taken into account.

Why the CPI Is Important

Even if you don’t wait with bated breath for new CPI numbers to release (and a lot of people do), I’ll bet you pay attention to inflation.  And even if your interest in new inflation rates is mild at best, I’m certain you care about the cost of borrowing or what returns you can expect when you decide to invest your money.  CPI impacts all of our lives to the extent that it is a key component of the inflation calculation, and to the extent that inflation metrics are key influencers of Federal Reserve policy.

It all trickles down from there: when the Fed raises or lowers interest rates, the costs of borrowing change, along with your ability to earn a stable return on your investments.  CPI has a direct influence on how much most Americans will ultimately pay for their homes, their cars, and what returns they can earn on their savings.  Other income instruments such as Social Security, pensions, and some financial instruments directly indexed to inflation s also rely on CPI data to determine their annual adjustments.  Even the determination of personal tax brackets, exemptions, and the standard tax deduction are all tied to CPI.  Given this influence, it is critically important that CPI be both relevant and accurate.

The Long-Standing Flaws of CPI

Even if we examine CPI by its own logic, it shows significant flaws.  For one, it does a poor job of reconciling price to value, as seen in the popular example car price variance.  Can a 1960’s model car be compared to a 2010-era car?  Features, projected useful life and maintenance costs sustained during that period should influence how we would compare the two.

Another glaring flaw in CPI relates to usage: when the price of a commodity like gas goes up, people simply use less of the commodity.  CPI ignores a basic behavior that finds consumers adjusting purchase volume in reaction to changes in price.

Timing is also a criticism of the CPI.  Though new figures and indexes are released monthly, the sample data that contributed to current period calculations may contain components that are several years lagging.

Finally, the market basket has come under scrutiny.  Do most households still buy a gallon of milk, a dozen eggs, and a loaf of bread every week?  Better yet, was the percentage of households that did every truly sufficient?  Doubt over whether the CPI truly succeeds in the proportional representation of buying profiles has always incited critics.  Its newest enemy is an extension of that doubt: a question about the role of choice.

New Flaw #1:  CPI Ignores Growing Diversity of Choice

Whereas the late 20th century was characterized by binary competition, modern markets are flooded with choice.  In 1976, Golden Grahams was among the only mass-market sweetened cinnamon cereals.  By 1984, Cinnamon Toast Crunch had entered the market. Simple brand competition found consumers one over the other based on a short list of variables (e.g., price and flavor preference).  Yet, modern consumers care about gluten content, organic ingredients, fat, sugar and carbohydrate levels, the use of whole grains, and a host of other factors that have led to unprecedented brand, and price, differentiation.   And there are far more than two competing brands.

According to Safeway.com, a 16 ounce box of Golden Grahams costs $5.19 ($0.32/oz.) while a 17 ounce box of Cinnamon Toast Crunch costs $5.19 as well ($0.31/oz.).   However, a 10.3 ounce box of Cascadian Farms Organic Cinnamon Crunch Cereal costs $5.49 ($0.53/oz.), and a 17.5 oz. box of Kashi Organic Promise costs $4.99 ($0.29/oz); another popular brand—Barbara’s Cinnamon Puffins, which are gluten-free, cost $4.99 for a 10 oz. box ($0.50/oz.)—are not sold on Safeway.com.

What this means for CPI is that, in order for it to be relevant, the calculation must accurately account for how many families are choosing alternatives, to what degree, and what the relevant price differences are.   Fluctuations in the price of cow’s milk hardly matter if the soy, rice, almond, hazelnut, and hemp milk industries are exploding (which they are).  The price of a 5 pound bag of conventional apples hardly matters if consumers are moving, en masse, towards organic.

New Flaw #2: CPI Ignores Dynamic Pricing

The information age has brought with it unprecedented capabilities, lowering barriers to entry, adding sophistication to supply chain management, and ushering in an era of dynamic, market-based pricing.  It has amplified the customer voice and equipped suppliers with a tool that is quickly killing the credibility of the CPI: frictionless price-setting capabilities and the agility of companies to react promptly to market conditions.

Dynamic pricing is not new—the travel and tourism industries have long-since used dynamic and differentiated prices for consumer staples such as airline tickets and hotels (and, of course, we see dynamic

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