Don’t Trust the CPI – Inflation is Hidden Somewhere Else!

by Gunther Schnabl

Both in Europe and in the US, interest rates have fallen to still very low levels and central banks have used unconventional measures to stimulate the economy. Nevertheless, officially measured inflation rates have remained low. While central bankers are proud of the high degree of price stability, many citizens feel their purchasing power diminishing. How does this fit together?

Inflation has more faces than rising consumer prices, as shown by German economic history. The hyperinflation of the 1920s, which was triggered by the lack of ability to pay war reparations, deprived the German middle class of its savings and thereby contributed to political destabilization. Since then, prices were controlled when monetary policy was excessively loose.

Before and during World War II, financing of government expenditure via the printing press, therefore, showed up in the form of rationing of goods. After the World War II, war financing via the central bank was paid by savings being devalued in course of a currency reform (1948). In Eastern Germany, where state-controlled prices were hiding the central bank-based subsidizing of loss-making companies, inflation emerged in terms of poor quality of scarce goods, bad services, and a dilapidated infrastructure.

Today, to compile a price index the statistical offices monitor the prices of a large set of goods and services, which represent the consumption habits of the population, for instance, food and beverages, housing, apparel, transportation, medical care, recreation, etc. The basket of goods is adjusted regularly according to changing consumption habits.

Beyond that, the authorities have changed the calculation method. In 1996, the US introduced the so-called hedonic price measurement. The statistically measured price is lowered, when the quality of a good increases. Meanwhile, about one-third of the US goods basket is affected (especially apparel, electrical appliances, and rents). However, if the quality of a good decreases, its price is not corrected upwards. This especially concerns food, where cheaper ingredients or an inferior quality are difficult to measure. Also, the quality and/or lifespan of toys, apparel, electronic products, and cars seems to have declined. The spread of reduced services, for instances at McDonald’s, Starbucks, IKEA, Southwest Airlines etc., has not tempted authorities to calculate prices upwards. Furthermore, since the year 2000, the Fed has removed the prices of food and energy from its inflation target, although (or because?) food and energy price are among the first ones to respond to monetary expansion.

Another loss of purchasing power concerns assets. Since the 1980s, the Fed’s and other central bank’s ultra-loose monetary policies have strongly boosted asset prices. The Dow Jones has risen by an average of 9% per year since 1990. Residential property prices have grown by 4.3% per year. Surging asset prices erode the purchasing power of particularly young people, who still want to acquire assets. Thus, high asset price inflation has dire redistribution effects among generations.

Inflation may be also hidden in a deteriorating quality of public goods such as roads, education, research, financial stability or social security. Public goods are not included in the price indices because they have no stated prices and/or prices are difficult to measure. Nevertheless, the citizens pay taxes and duties, which have tended to increase faster than wages. It is an open question if the scope and quality of public goods have improved accordingly. Many citizens would deny it.

The shadow inflation index for the US, which claims to calculate inflation since 1990 without any systematic changes (, has risen on average by 8.5% per year, while the core inflation rate has remained close to 2%. This suggests that monetary policy decisions do not follow the inflation target, but rather the way of measuring inflation is adjusted to the inflation target. Keeping measured inflation low is a way to save costs for the public sector because social security expenditures and pensions are adjusted based on official inflation numbers.

Many central bankers and politicians claim that high perceived inflation rates are due to Murphy’s law. But citizens should be alert because the official consumer price indices are far from being a measure for the purchasing power of the people.

7 thoughts on “Don’t Trust the CPI – Inflation is Hidden Somewhere Else!

  1. This is an interesting topic because the money stock has nearly tripled since 2008 – inflationary by definition – though the general level of prices hasn’t tripled. We do see the stock market indices have more than trebled which I think is where inflation, being a heterogeneous phenomenon, is most noticeable. It’s hard to say whether this increase will be reflected in consumer price indices because the market’s productivity often beats inflation. The classic example would be in computing where capabilities have improved by quite a bit more than three-fold over the decade. Paradoxically, the success of the market system is so large that it often masks the inefficiencies introduced by state intervention.

  2. “Beyond that, the authorities have changed the calculation methodology.”

    The calculation *method* not methodology.

  3. Yes, Fritz Machlup insisted on the difference between “method” and “methodology.” But the distinction is almost universally ignored. Part of the reason is that among “true scientists” no-one does methodology (philosophy of science)! Another issue is the misuse of the words economics and economic. It started perhaps with the misnamed “American Economic Association” instead of the “American EconomicS Association.” Or maybe they meant that the association was going to be economical in its cost-structure.

  4. On the main issue: The point here is that the focus of central banks is on one set of prices while the author believes that another set of prices is ultimately more important. Keep in mind that inflation in the usual sense of the word is not a prerequisite for economic trouble as recent history has shown.

  5. Prof. Schnabl raises a number of important points.

    As Alchian and Klein pointed out decades ago, consumer prices are a subset of the “prices” of monetary theory. Both the Austrians and Keynes knew that monetary shocks can work first through asset prices and only later through final goods prices. That is the transmission problem.

    There are offsetting effects with goods prices. By the time new technology and new goods get incorporated into price indices, most of the cost savings have already occurred. To that extent, CPI overstates inflation.

    Bottom line, CPI is a flawed measure of prices.

  6. Around 1996, the CPI also used a “substitution factor” in calculating cost of living. A brainchild of Sen.Daniel Patrick Moynihan, increased prices are not included if substitutions are available. Thus if one is used to eating top sirloin steak but had to go to hamburger, and later to fish or chicken because of increased prices, such increases do not figure into the calculation.

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