Why CPI does not capture the inflation you feel

For years now people have been complaining about the CPI, that the inflation that they are experiencing is not adequately captured by the measure. I want to show in a few simple graphs why that is the case.



Here I have plotted the Case-Shiller National Home Price Index along with CPI, where both are indexed to be equal in 1990. What we see is that the growth in home prices has wildly outpaced CPI. In fact, home prices are about 33% higher than where CPI would expect them to be.

But CPI is weighted to represent how much people spend on certain items. Thus, around 40% of CPI is weighted toward housing. So why is CPI not capturing this? Because instead of just using home values, they use something called Owners' Equivalent Rent of Residence:



Look at that graph and you tell me how you think this measure has performed.

I thought that this would be interesting to talk about, and problems like this cause many Americans to ignore economic measures because they do not reflect the reality that they face.

Finally, I believe that this graph represents a major source of frustration for many Americans:



I have shown here a simple new home sales price to median family income indexed to 1975. By this metric, home prices are 50% higher today than they were in 1975 (and I am not even correcting for the much higher percentage of two income households of today). If you are wondering why many have become dissatisfied with our economy and are turning to more radical politics, I would assume that this is a major source.

grocery prices in the past 9 years have gone up on average 35% to 60%; who the **** can afford to eat?

cuban smokes said:

grocery prices in the past 9 years have gone up on average 35% to 60%; who the **** can afford to eat?

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Not to mention the fact that we are now using more grain fed meat and other agricultural atrocities that take place in order to put a lid on how much food prices rise.

when I was 16 a gallon of gas was .25 cents

when my Dad was 16 a gallon of gas was .10 cents

that is a .15 cent per gallon rise in 35 years, from 1941 to 1976; < 1/2 cent per year increase over the period

since the late 1970s prices on everything have pretty much gone to Hell = inflation .............

cuban smokes said:

when I was 16 a gallon of gas was .25 cents

when my Dad was 16 a gallon of gas was .10 cents

that is a .15 cent per gallon rise in 35 years, from 1941 to 1976; < 1/2 cent per year increase over the period

since the late 1970s prices on everything have pretty much gone to Hell = inflation .............

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But hey, at least we can buy phones and McDonald's for cheap. That makes up for it, at least that's what I'm told.

Because it is no longer designed to.

The short story is, once more started looking at CPI and the government found out it could manipulate it... they did. And understand that the government has changed the math on this at least a dozen times in the past 20 or so years. They have every motivation to do so, if they could manipulate CPI into a smaller number then they could understate the need for social safety net spending increases because of inflation.

Of course the painful story is far more complex, but that boils down to a shift in what CPI once measured and what is really does today.

The original idea for CPI was to compare the prices for a fixed basket of goods and services between two points in time. As a "cost of goods index" the real measure was just any increase in the costs of that fixed basket no matter what the reasons were.

However, once Congress realized that the measure would "overstate" inflation from time to time, they decided to pivot the measure to a modified "cost of living index."

Basically, if consumers bought less of a product because of cost or quality then the substitution or replacement was allowed. For instance (and just to illustrate the point,) if buying a bag of 20 apples got too expensive then all of a sudden they would start buying bags of 12 or less. That allowed the two points in time to adjust for spending habits by quantity buying habit responses to the prices themselves, not the actual cost increases of an apple in any quantity between two points in time. Another for instance (and this is real,) if less people were buying cable TV and started buying bundle deals with Internet and/or Phone then the there would be a substitution (sometimes called quality) in the basket which also manipulated the actual costs of cable TV over those two points in time.

The older measures of CPI assumed quantities and qualities as being fixed so the measurement came down to cost increase alone. The new measures of CPI allow for quality and quantity to vary, and that tends to do the opposite of the original methodology by *understating* inflation as it came to cost of living as a response to cost increases. When you allow too much of the CPI math to be a variable, then government gets the ability to report a lower CPI based inflation. Therefor they can force those who live on social safety nets to purchase less and of a lower quality and call it "maintaining a a cost of living."

This does two things to just about everyone.

One, it reports by lag. Because it makes CPI no longer a measurement of rising prices but rather consumer spending response to rising prices, we get a reporting of the results long after the reason has already been economically impacting.

Two, it bypassed the consideration of money itself. We no longer know what it actually costs for a basket of goods and services, all the modifications and substitutions for quality and quantity distort the results between any two points in time.

What you 'feel' from inflation is not really reported.

The general idea is because of what you feel from inflation not reported, you change your spending and never really know why until you have done so.

You have to understand that the CPI cannot simply capture everything effectively, especially incredibly variable and volatile things like food and housing. The simple answer is that trying to make an effective CPI is very hard. Try averaging out the cost of living in San Francisco and Omaha, Nebraska and see what you get, something unrepresentative of both.

cuban smokes said:

grocery prices in the past 9 years have gone up on average 35% to 60%; who the **** can afford to eat?

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Inflation adjusted food has never been cheaper so long as you avoid the processed stuff, which a lot of folks say you should be doing anyways.

Carjosse said:

You have to understand that the CPI cannot simply capture everything effectively, especially incredibly variable and volatile things like food and housing. The simple answer is that trying to make an effective CPI is very hard. Try averaging out the cost of living in San Francisco and Omaha, Nebraska and see what you get, something unrepresentative of both.

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The bigger problem is that it was decided that we need to keep the number down because government costs are now often pegged to the official inflation number, and because lowballing the number was expected to make it easier for elected officials to keep their jobs, these being the same elected officials who oversee how the number is made....which works up till the point that folks figure out that they are being lied to.

Housing yes, but it is pretty clear that the CPI does not correctly pick up medical inflation, which even by the official numbers is again running at multiples of general inflation.

Carjosse said:

You have to understand that the CPI cannot simply capture everything effectively, especially incredibly variable and volatile things like food and housing. The simple answer is that trying to make an effective CPI is very hard. Try averaging out the cost of living in San Francisco and Omaha, Nebraska and see what you get, something unrepresentative of both.

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It is understandably difficult, but when we're at the point now where the CPI measure of housing costs so far lags actual housing costs, then the criticism needs to be accepted and acted upon.

Hawkeye10 said:

Inflation adjusted food has never been cheaper so long as you avoid the processed stuff, which a lot of folks say you should be doing anyways.

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It's precisely the processed stuff that makes food prices appear so cheap. Go check out how much it costs to get a pound of grass fed beef and then tell me about how "cheap" food is.

phattonez said:

It is understandably difficult, but when we're at the point now where the CPI measure of housing costs so far lags actual housing costs, then the criticism needs to be accepted and acted upon.

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The problem with measuring housing is that the biggest increases in costs are in areas like San Francisco or New York, which drives the overall average cost up much higher but is not representative of the country as whole. It is then hard to create policy when only specific areas are experiencing higher than normal inflation in certain costs.

Carjosse said:

The problem with measuring housing is that the biggest increases in costs are in areas like San Francisco or New York, which drives the overall average cost up much higher but is not representative of the country as whole. It is then hard to create policy when only specific areas are experiencing higher than normal inflation in certain costs.

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It's not just those two cities. My current city has insane housing prices. My parent's city has seen housing costs double over 10 years in a mid-sized city. Many markets across the country have ballooned. I think prices are rising everywhere outside the stix and the rust belt

Carjosse said:

The problem with measuring housing is that the biggest increases in costs are in areas like San Francisco or New York, which drives the overall average cost up much higher but is not representative of the country as whole. It is then hard to create policy when only specific areas are experiencing higher than normal inflation in certain costs.

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Where exactly have you not seen home prices increases drastically over the past few years? While certain areas may be far cheaper than others, trends are similar across the nation.

The inflation rate often used quality adjustments. Also item substitution when a particular item rises to much.

Examples

Your computer. An average computer in 1990 would have cost $2000 for a computer with 1/100 of the power of a $500 dollar computer. So for computing power the inflation rate is more than likely extremely negative. The same would be applied for any products with computers in them, from phones to card at less deflationary levels.

The item substitution would see the T bone steak replaced with a blade steak then to ground beef then to pork as prices for specific items go up. As to when they would go back to a T Bone and how they would make the price adjustment I do not know.

The government has a strong interest to manipulate inflation rates both for social security and for social stability.

phattonez said:

For years now people have been complaining about the CPI, that the inflation that they are experiencing is not adequately captured by the measure. I want to show in a few simple graphs why that is the case.

Click to expand...

You have more than 3,100 separately functioning economies with more than 1,500 labor markets in the US.

So, no, there is no real way to capture prices except to aggregate and average them.

Owners' Equivalent Rent of Residence also includes rental prices, which are increasing in many of the larger MSA's.

While your graph might show new home prices increasing by 50% since 1975, the CPI-W has increase 361.7% since 1975.

Lord Tammerlain said:

The inflation rate often used quality adjustments. Also item substitution when a particular item rises to much.

Examples

Your computer. An average computer in 1990 would have cost $2000 for a computer with 1/100 of the power of a $500 dollar computer. So for computing power the inflation rate is more than likely extremely negative. The same would be applied for any products with computers in them, from phones to card at less deflationary levels.

The item substitution would see the T bone steak replaced with a blade steak then to ground beef then to pork as prices for specific items go up. As to when they would go back to a T Bone and how they would make the price adjustment I do not know.

The government has a strong interest to manipulate inflation rates both for social security and for social stability.

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The massive deflation in technology prices has been fantastic. I only wish that we could have had that massive deflation in the items that we spend the most money on.

Mircea said:

You have more than 3,100 separately functioning economies with more than 1,500 labor markets in the US.

So, no, there is no real way to capture prices except to aggregate and average them.

Owners' Equivalent Rent of Residence also includes rental prices, which are increasing in many of the larger MSA's.

While your graph might show new home prices increasing by 50% since 1975, the CPI-W has increase 361.7% since 1975.

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My graph does not show that. It shows that the home price to income ratio has risen 50%. Home prices have grown orders of magnitude since 1975. What I wanted to show is that home prices have increased faster than incomes.

phattonez said:

What I wanted to show is that home prices have increased faster than incomes.

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But not faster than wealth (for which real estate is a subset of domestic assets)....



So what is the point of this thread... are you going to make another prediction? :lol:

Kushinator said:

But not faster than wealth (for which real estate is a subset of domestic assets)....

So what is the point of this thread... are you going to make another prediction? :lol:

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Net worth, which of course is not corrected for population growth. Find us average or median net worth and then show us that comparison.

phattonez said:

Net worth, which of course is not corrected for population growth. Find us average or median net worth and then show us that comparison.

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Whoa now... it was not intended to account for population growth. When we consider capital mobility, your entire argument falls apart.

No predictions?

edit:

Kushinator said:

Whoa now... it was not intended to account for population growth.

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Obviously, but that's why we ought not be using it here. It would be like a ratio of home prices to GDP, which would show a steady decline, which doesn't mean anything either.

When we consider capital mobility, your entire argument falls apart.

No predictions?

edit:

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I'd love for you to explain to me how median wealth can possibly increasing when incomes are not rising as quickly as home prices and savings rates have decreased. When 62% of Americans have less than $1000 in savings.

https://www.marketwatch.com/story/most-americans-have-less-than-1000-in-savings-2015-10-06

phattonez said:

Obviously, but that's why we ought not be using it here. It would be like a ratio of home prices to GDP, which would show a steady decline, which doesn't mean anything either.

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Neither housing price indexes or name your price ratio are adjusted for population growth... because doing so makes no sense. Your argument is easy to see. You're trying to make a point regarding the end of the gold standard and wage growth, while failing to account for gains in net wealth.

I'd love for you to explain to me how median wealth can possibly increasing when incomes are not rising as quickly as home prices and savings rates have decreased. When 62% of Americans have less than $1000 in savings.

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Why would i have to explain anything of the sort?

phattonez said:

For years now people have been complaining about the CPI, that the inflation that they are experiencing is not adequately captured by the measure. I want to show in a few simple graphs why that is the case.

Here I have plotted the Case-Shiller National Home Price Index along with CPI, where both are indexed to be equal in 1990. What we see is that the growth in home prices has wildly outpaced CPI. In fact, home prices are about 33% higher than where CPI would expect them to be.

But CPI is weighted to represent how much people spend on certain items. Thus, around 40% of CPI is weighted toward housing. So why is CPI not capturing this? Because instead of just using home values, they use something called Owners' Equivalent Rent of Residence:

Click to expand...

Perhaps you should explain why Owner's Equivalent of Rent is used instead of house prices.

The real reason the CPI doesn't represent any individual's experience is that it is the weighted average of thousands of goods. Nobody buys everything in the CPI every month and not in those proportions. And it is the average of Urban consumers...The entire state of Montana is excluded from the survey, as is most of New Mexico and at least one of the Dakotas.

Kushinator said:

Neither housing price indexes or name your price ratio are adjusted for population growth... because doing so makes no sense. Your argument is easy to see. You're trying to make a point regarding the end of the gold standard and wage growth, while failing to account for gains in net wealth.

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I'm making a point that median home prices are surpassing median incomes.

Why would i have to explain anything of the sort?

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Because the reason for the effect that you're seeing is due to widening inequality, pushing up averages far higher than medians. It means that while average wealth is growing more quickly than home prices, median wealth is probably not, which is why we see the relationship that we have with median incomes.