What Is Inflation And How Is It Measured

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In emails I received and discussions I saw and experienced there is a strong belief that independent measures of inflation (e.g. www.shadowstats.com, the Chapwood Index) are false and not trustworthy. I wanted to address this issue and show you how the rate of inflation is measured today – the CPI relied on by the most important institutions all over the world – historical background of it. Finally, I will compare different methods to find out which one is closer to the truth.

What are inflation and CPI and how are they measured?

Until 1980, the rate of inflation was reported as an increase of the money supply in circulation. The more means of payment the bigger inflation. It was very simple and transparent system. After 1980, a new way was introduced – an attempt to quantify a change in living costs. A Consumer Price Index (CPR) was created.

According to the government, more important than estimating inflation was to show an increase of citizen’s living costs. Money is not distributed evenly in the economy and this is why a 10% increase in money supply doesn’t need to push the price of milk by 10%. The CPI is not a measure of inflation but the difference in prices of goods and services, year to year.

Reason behind the change           

After World War 2, the “Great Society” and the Vietnam War increased the expenditure of the US government and the amount of USD in circulation was growing faster than gold reserves. In the ‘60s, the jump was big enough that European leaders questioned the solvency of America.

The US gold stock was quickly disappearing when a massive rush to exchange USD for gold (at 35 USD/oz Bretton Woods rate). In 1971 Richard Nixon suspended convertibility of the USD to gold.

After the dollar was divorced from gold, it was never fixed again. Unfortunately for the American currency, the trust towards dollar was harmed and it led to quick depreciation. The answer came in a form of a deal with Saudi Arabia in 1973, when the US government created the petrodollar. The USD was going to be the only currency in oil trade. In 1975 OPEC was created and the new status of petrodollar was sealed. To stop the dollar from falling Paul Volker, chairmen of the FED, raised interest rates to 20%. This brought back the trust in the currency by changing the negative trend. To sustain the level of interest rates and keep the trust, the method of measuring inflation was changed and CPI came to life.

Controversy around CPI calculation

The Consumer Price Index (CPI) is nothing else than a basket (index) of goods with products of everyday use, food, private and public sector payments (bills etc.).

In order to count inflation with the CPI, we exclude the goods most prone to change. Every year a new basket is indexed. We remove the top 20% of prices that changed the most in the last month or year. What is left is cut again by 15% truncated mean. This translates into removing top 15% of those goods that climbed in price and 15% that lost the most. Then, we arbitrarily add substitutes having in mind rigidity of prices.

Using this method stirs a lot of discussions. When the supply of currency is increasing each year (quicker than the sum of goods and services in the economy) prices of those goods and services are also going up. This makes people responsible for the CPI to remove more goods that become expensive than goods that got cheaper.

Another problem with the CPI methodology is wrong subsidiarity of goods. According to the assumption behind it, given a possibility to buy a cheaper substitute, the consumer is going to choose this product – and will not feel the price hike (so much). This is true but does not offer the big picture of the situation. If I can afford a good ham today but only canned spam tomorrow, am I not becoming poorer? Does it matter when as a consumer I have to compromise when buying goods because of the high price? Of course, it does. Even economists are far from saying that those two are substitutes but for clerks from the Bureau of Labor Statistics (BLS) which publishes the CPI, it works fine.

John Williams’ index – an alternative for investors

The method of calculating John William’s index is not available. From data presented on the Shadowstats website official numbers from the BLS are multiplied by a set of constants and give the result. Alternative numbers are visibly higher than the CPI (see chart below). Blue line is Shadowstats inflation and red is the BLS number.


Looking through the CPI scope, Williams’ method of computation is wrong but its results are correct. Index presented on www.shadowstats.com mimics the increase of the M3 money supply in circulation (the original way of counting the rate of inflation).


Source: Self-made

Looking at numbers published by the FED, the amount of dollars grows geometrically and doubles every 9 years – similarly to Williams’ index. Even with obscured methodology, numbers are correct. What about the cost of living? Does Shadowstats overestimate them? Fortunately, apart from the official CPI, we have another independent index to verify Williams’ data.

The Chapwood Index

The Chapwood Index is a tool to estimate costs of living, very similar to the CPI. Creator, Ed Butowsky, decided to design a credible index without controversial factors of the BLS method. Especially with constant shares of products in the basket.

The shares and goods in the basket are based on data collected while surveying a representative group of the middle class. Over 500 goods and services bought most often by consumers create the basket.

The Chapwood Index is sourced with information from 50 cities from the majority of the States. This is a compromise between cost of data acquisition and verifiable results from representative regions of the US. Butowsky’s organisation updates database with fresh prices each quarter and after averaging the Chapwood Index is delivered as a y/y change. Thanks to this method everyone can follow the change in living costs in his State.  In 2015 the rate of inflation ranged between 5.9% in Phoenix, Arizona and 13.4% in Portland, Oregon.

This confirms Williams’ information – 8-10% inflation in the recent years.

Uneven spread of the money supply in the economy

Consumers spend their money not only on everyday goods but also buying financial instruments – which are not included in the CPI basket. This is why measuring the rate of inflation by looking at the price of bread throughout the years is false.

Oversupply of printed dollars found its way into several sectors of the economy. Prices of gold or oil are controlled by governments but assets – priced by the rules of (mostly) free market – give the true picture of devastating inflation. A good example is the real estate market, which grew by 300% since 1980 and experienced bursting bubble on the way, quintupling the price.



Apart from the real estate, there are also bond markets – in practice experiencing an ever growing price. According to the mechanism: higher price, lower yield; We can see that interest from owning government bond is falling (chart below).


Similarities can be easily found by looking at NYSE where S&P500 is at record heights. The chart below shows another correlation, this time between S&P and Mei Moses Index (index of art). In the last decades, due to low supply of physical gold (vis-à-vis dollar) and problems in bulk sales of gold, art became an equivalent of precious metals. Because art – just like physical metal – is not someone’s debt.


Source: etf.com

You can find those proclaiming that technological progress lifts the equity prices up thanks to productivity improvements. This is false. Before the World War I, the US boasted the gold standard and supply of currency was limited, the industry was developing rapidly. Dynamite, power tools, bulb, radio, airplane, combustion engine. All those, and much more fuelled the economy but the equity prices were very stable for decades.

http://www.valuewalk.com/wp-content/uploads/2021/07/clost.pngThe chart above is an average capitalisation of equity in the USA since 1870 and over 50 years that followed. While economic growth was strong, equity market doesn’t need to grow infinitely. If this happens it is due to printing presses of central and commercial banks. A great example of that is 1920s bubble initiated by very low-interest rates and high supply of money. After the burst, the stock market crashed and the Great Depression of the ‘30s started.


John Williams’ methodology has few flaws. This doesn’t change the fact that the result is parallel to the Chapwood Index. The increase of M3 money supply gives another proof to confirm what before 1980 was understood as the measure of inflation.

The M3 supply of money probably overestimates the average increase in prices – due to rising productivity, historically revolving around 1.5%. Knowing that the level of overestimation equals 1.5% we can subtract it from Shadowstats result (8-10%) and the end result of 6.5-8.5% is the lower end of Chapwood Index. Everything seems to check out. Everything, but the official CPI trying to convince us that inflation equals 1%.

To put it bluntly – there is no one perfect formula to calculate the rate of inflation or the difference in living costs. What Shadowstats offers is an overestimation but after comparison to other independent indices and the pre-1980 method of measuring inflation, this overestimation we are talking about is less than 2%. This is why official data is false and is not confirmed by the reality we live in. I am aware of the flaws Shadowstats and Chapwood Index have but they are more trustworthy than anything else out there.

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