Wednesday, May 28, 2008

Lies, Damned Lies, Statistics, and the CPI…

If statistics are the highest order of lies in this phrase about the three types of lies commonly attributed to 19th Century British Prime Minister Benjamin Disraeli, then the US government’s Consumer Price Index (CPI), compiled by the Bureau of Labor Statistics (Minicrap for the Orwell aficionados), is the celestial be-all and end-all of lies. Your Genteel Moderator begs your indulgence as he addresses what to some may be an arcane matter of economics. But the continued use by the government of a CPI based on the price of treacle and fairy dust demands our attention.

But why, you may ask? Because, unless you happen to live in Never-Never Land, you may have noticed that treacle and fairy dust do not make up a substantial portion of your monthly expenditures. Off the top of your head, estimate the top 10 costliest expenditures by month that you and your family incur. Would fuel be one of them, perhaps? Do you then imagine that an index compiled to measure the relative increase in the cost of living and from which the inflation rate is essentially derived should reflect that relative weighting? Many people would share your views, but apparently not the Bureau of Labor Statistics. Because they believe that fuel (gasoline and diesel for motor vehicle use) accounts for just under 5.5% of your monthly expenditures. In fact, according to today’s CPI formulation, energy costs account for less than 10% of your total monthly expenditures. That may be so for the Hollywood glamoratti and the Greenwich Hedge Fund Manager, but for rather more ordinary people, not so much.

The easiest way to calculate annual inflation is by using the CPI in the same months from two consecutive years, subtracting the base year from the second year, dividing the result by the base year and multiplying by 100. For example, the CPI for April 2007 was 206.686 and for April 2008 was 214.823. Therefore, CPI derived inflation year-on-year to April was 3.93%. Of course that’s based on a CPI weighting that puts gasoline costs at less than 5.5% of your expenditures and total energy costs at less than 10% of total expenditures. Let’s look at the price of gasoline for the same period. According to the US Energy Information Agency the average price of regular gasoline across the country has increased by just under 73 Cents in the past year (as of May 26). Using the same method of calculation as CPI derived inflation, then average US price for regular gasoline has increased by 22.68% in the past year (although I would like the Energy Information Agency to show me where I can get gas for $ 3.93 a gallon!). We could run through home heating oil as well but suffice it to say that that too has increased, if not as dramatically. For diesel fuel, a significant distribution cost driving food and other price increases, the increase is much more dramatic at 67.66%. That means at least a two thirds increase in the cost of getting goods to market (unless you distribute by sailboat of course). The point is that with gasoline prices having risen by nearly 23% (and diesel by nearly 68%), the CPI derived inflation rate of 3.93% is nonsense.

There have been and continue to be numerous criticisms of the CPI based on everything from sound economic theory to politically based tinkering. A quick review of internet based resources alone will give you more information on the subject than you could possibly want. But it is difficult to argue with the fact that a year on year inflation rate of 3.93% seems absurdly low in view of sky-rocketing energy costs. Add to this picture the falling value of the USD (which by some measures has fallen by more than 30% since 2000) driving up the cost of imports (i.e. virtually every manufactured good that you buy these days) and what we have is the portrait of an economy in real crisis. Add to this the substantial decline in relative liquidity, i.e. the widely touted “credit crunch”, and we have a potential Perfect Storm brewing, and certainly a rather sticky conundrum for monetary policy.

In any event, not only are gasoline prices painful and inconvenient, they are also having a multiplier effect on the much discussed recession that the government is vastly understating through a highly distorted CPI. The Bloated Plutocrat had this to say. “If you are relying on government statistics to understand the economy old boy, you are going to lose your shirt. Run for the Swiss Franc and Gold Bullion. The equity market is a total bear and the bond market is going to be flooded with punters and prats! Nothing’s going to change in the near term and neither one of the esteemed Senators likely to be elected in November have the intellectual capacity or political power to do a damned thing about it. Aside from the global shift in economic power away from the US in general, we are looking at conditions that bear some resemblance to the late 1970s, but without a Ronald Reagan to convince us that everything is going to be just fine.” The Bleeding Heart was somewhat less enlightening. “I suppose that the fuel / energy cost weighting in the CPI should be substantially increased, especially as those costs are disproportionately impactful on lower income groups. I know that fuel costs are definitely driving up the cost of tickets on the Martha’s Vineyard Ferry this summer!”

A CPI that weights total energy costs at less than 10% of one’s total monthly expenditure is at best inaccurate and, at worst, fraudulent. Were these costs more appropriately accounted for, adjusted inflation would likely be upwards of 5%, a level that is extremely disconcerting when looking at interest rates. Nevertheless, don’t expect a change in the CPI basket any time soon, the BLS think it works just fine…

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