When measuring inflation, most refer to the Consumer Price Index or CPI. In fact, its use has become so pervasive that cost-of-living adjustments in contracts are based upon the CPI. With so much reference to this number, should not we understand it? The fact is that the index is more adulterated than ice cream. As we will see, the index is biased on the low side thereby understating price increases. Let's look at some of the components.
The Bureau of Labor Statistics is charged with the construction of the index. There have been so many alterations in the index that today's CPI is not comparable to that of previous years. This alone makes comparisons of 2000's CPI with that of 1950 fairly meaningless. Measuring inflation is this way is inaccurate.
In the early 1980s, the cost of a new car was put on a twelve-year moving average. The true cost is spread out and thus delayed. So the cost of a new automobile is muted for over a decade.
The housing component is grossly misstated. This component is about 40 percent of the total index. In 1983, real estate was mostly replaced by rents. The idea behind this decision was that a house is an investment and not a part of the cost of living. So real estate is an investment while rents are seen as the cost of housing. This may not be accurate. Rents are controlled in many areas and are not an accurate representation of price trends.
The housing component is derived from the Federal Housing Administration (FHA). The FHA sets a maximum price of $60,000 on a house. This is obviously very low and not representative in most parts of the country.
Some cost increases are not reflected in the CPI because they are deemed to be only changes in "appearance". If certain changes are made to an automobile, the increased cost will not be reflected in the CPI if those changes are judged to only be changes in appearance. This judgment is left up to the government.
"Quality" considerations introduce another distortion. When pollution devices were added to cars, the added cost was not reflected in the CPI because this added to the quality of the car. The consumer had something that he did not have before, thus there was an increase in "quality."
There is one more cost that is not included in the CPI-the cost of government. Taxes rise, we pay them, but there is no increase in the price index.
As you can see, the CPI understates the cost of living. To get a more accurate picture, simply look at your own cost of living-just look at the cost of a new car or your rent. Look at the cost of commodities. Even the Fed said that they would look more closely at the commodity markets in order to judge monetary policy. If we were to look at a long-term graph over hundreds of years, we would see that costs have risen with only certain plateau periods where costs go sideways. The great deflationary depression of the 1930s was a rare occurrence.
Of course, this understatement benefits the government in hat they can claim that inflation is under control. Business also benefits because many contracts have cost-of-living adjustments based upon the CPI. The lower it can be kept, the better.