Understanding CPI & National Inflation Numbers [CPI Is Not A Cost Of Living Index]
If the current CPI and inflation rate is so low, why is my cost of living going up? How can there be high inflation on the horizon when the reading is so low?
There is a lot of talk about inflation and the national inflation numbers. However, people are becoming more confused with the headline reports given by the media, analysts, economists, government, and banks, when compared to what a large number of other economists and investors are saying. On one hand you have the government, central banks, and some economists stating that inflation is low in the 2% range, and that it is not a threat. This is being broadcasted in the news by the media and analysts on a daily basis. On the other hand you have some other economists, and investors such as Warren Buffett, warning of massive inflation down the road. I also fall into the camp that views inflation as a likely problem in the upcoming future (see links to my older posts on the causes of upcoming high inflation at the end of this article).
Now one may say how can 2% and a target around 3% inflation possibly be considered high? Especially since in the last 10 years it has stayed at a low level? What is the source of your information? What are you using to calculate inflation?
The confusion and conflicting information comes from the definition of inflation used, and what people are referring to when they use the term. The problem is that the term “inflation” refers to something general in the common English language, as well as to a gauge or measurement of inflation that has been calculated using a specific method. This creates widespread misunderstanding that increases the confusion and conflicting information.
Measures of inflation
When I talk about inflation, I am not talking about the official and national inflation rates calculated by the central banks (that are based on the national Consumer Price Index). I refer to inflation in the general common English language sense, which is the increase in prices of goods & services, increase in the associated costs of living, and decrease of purchasing power, over time. This is the normal everyday term of inflation that the average person relates to and associates with when they open their wallet or pay the bills. The effects of inflation can be seen not only in prices of goods & services purchased, but also on retail bank loan rates, taxes, real estate, as well as other items. On a separate note, there is also confusion about “interest rates” and the “prime rate”, as people use the terms to refer to both the central bank and retail bank’s versions. These are very distinct and different as well, and we will save that topic for another day.
What Are The Differences?
Inflation (standard/general/common) – The overall general upward price movement of goods and services in an economy. An erosion in the purchasing power of money.
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. [from BLS – US Bureau of Labor Statistics]
The Consumer Price Index (CPI) is the most commonly used gauge for measuring inflation. Most nations use their official CPI data for inflation, which is supposed to represent the most common goods consumers purchase. “Core Inflation” or the “core rate” is measure of inflation which excludes specific items from the CPI that face more volatile price movements. Food and energy prices are excluded to give what they deem a more strict measurement of general prices. Each nation has slight differences in what is included in their basket of consumer goods & services, and the way sample data is collected.
The Producer Price Index (PPI) is a family of indexes that measures the average change over time in the selling prices received by domestic producers of goods and services. PPIs measure price change from the perspective of the seller. This contrasts with other measures, such as the Consumer Price Index (CPI), that measure price change from the purchaser’s perspective. Sellers’ and purchasers’ prices may differ due to government subsidies, sales and excise taxes, and distribution costs. [From BLS]
The Wholesale Price Index (WPI) was the name of the program from its inception in 1902 until 1978.
So when you hear the government, politicians, media (tv, radio, internet, newspaper, magazines), analysts, most economists, central banks, and retail banks, use the following terms, they are usually referring to the nation’s official inflation rate or numbers, as measured by the Consumer Price Index (or a subset of it, as in “core”):
– inflation rate
– reading of inflation
– headline inflation
– headline CPI
– CPI inflation rate
– Consumer Price Index
– Price index rate
– national inflation
– annual inflation
– monthly inflation
– economic inflation
– headline core inflation
– core inflation
– core rate
– growth rate
note: I’ve even heard the radio describe the CPI as a gauge for the “cost of living”, as well as saying that “the cost of living increased” to describe that the CPI increased. However, StatsCan and the US Bureau Of Labour Statistics specifically say that the CPI is not a cost of living index. See links below, and section on misconceptions and limitations.
The central banks measure inflation using the CPI because it provides them with a standardized method & data set that can be controlled. This standardized metric is used as tool for making their policy decisions, as well as for reporting & tracking. For their purposes they do not need to measure increase/decreases in every single item in every single category, nor is it practical or efficient to do so. They believe that the CPI is an adequate representation. In any case, this definition/method may not be that useful to us as it is to the central banks.
For further information on the official national inflation rate, the corresponding CPI, and its calculation, please refer to the following:
USA (Bureau of Labor Statistics BLS)
China (National Bureau of Statistics of China):
Misconceptions & Limitations
One of the most common misconceptions is that CPI is a cost of living index. However, because the term inflation describes the erosion of purchasing power which translates to higher costs of living, this then presents some conflict with the central bank’s use of CPI to measure inflation.
Another limitation is because the objective of the CPI is to measure pure price change, the quantity and quality of the goods & services included in the CPI basket need to be held constant. However, in the real world, quality & quantity changes constantly. We see new models & varieties of goods/services replace earlier ones, and in differing quantities, as well as levels of service. Many times the prices of these new goods/services are also different than previous ones, but may not necessarily be better. However, the prices for many new items and services tend to be higher than their predecessors. Not the best examples, but for example service level decreases in your cell phone plan. Evening minutes used to start at 5:00pm, now it starts at 9:00pm, while the price may have stayed the same or has even changed. Such a “feature” is added as a option package, and not on a per minute basis. Such an option package is always available, but the fine details are changing. In many cases a different combination of options have been introduced. Another example is the changes to GB caps on internet usage, where the monthly prices have not changed for the product (internet access at a particular speed). These minor detail type of quantity/quality decreases may not be reflected in the CPI.
Included in the CPI are taxes that are directly associated with the purchase of specific consumer goods & services (sales & excise taxes). Government user fees are also included such as toll charges, parking, national park entry fees, etc. However, the CPI excludes taxes that are not directly associated with the purchase of consumer goods and services. These are taxes such as income, Social Security, and other similar forms of tax. Similarly, the government services that are paid for through taxes are also excluded. The taxes that are not included in the calculation are one of the most significant factors that adversely affects (erodes) our purchasing power.
The CPI does not include investment items, such as stocks, bonds, real estate, interest on savings, and life insurance. These items relate to savings/investments and are not considered day-to-day consumption expenses as per the objective of the CPI. However, all these items do affect an individual’s financial status. Compare a high of 1.75% for interest on savings compared to 3% not that many years ago.
Property taxes are reflected indirectly in what the BLS calls “owners’ equivalent of rent”, which measures the cost of the flow of services provided by shelter, to the extent that these taxes influence rental values. Regarding real estate, in Canada, owner-occupied housing combines both consumption and investment elements, and the CPI is designed to exclude investment items. “rental equivalence” measures the value of shelter to owner-occupants as the amount they forgo by not renting out their homes. This may not be an accurate representation of inflation seen in real estate.
Bank Lending Rates
As we have seen the retail banks have not followed the central bank’s increases. The central bank has held steady on their lending rate. However, retail banks have increased theirs. In Canada, the current retail banks have had their prime lending rate fluctuate up & down in the range of 2% – 2.25%, and posted closed 5 year fixed mortgage rates have increased to around 4.7% – 5.50% in the last year or so. The retail banks have eliminated subtraction of a base number from variable rate mortgages, and have added +1% to prime on secured lines of credit nowadays.
Retail banks can change rates whenever they want based on their profit requirements and gauges of future inflation & growth. Although they still would look at CPI, they would also use different models, calculations, data, and also look at a variety of other price indexes as well (retail, industrial, raw materials, farming, etc). They have a number of different uses for both the present and forecasted inflation and growth numbers, as they impact their margins on income made from a variety of lending. They have different metrics that suit their particular purposes. The loan rates are not part of core inflation or the national inflation rate, but increases are definitely considered inflationary.
What National Inflation Rate Is Considered High?
– Economists, and central banks differ but generally consider the national inflation/growth rate of around 2-3 to be acceptable and manageable. They consider a rate above 4 to be quite high, and undesirable. To put this into perspective China estimates (wants) their national inflation rate at around 3.0% in 2010. It is more likely that they will have trouble containing it and will probably be around 4.0%. While China’s economy has slowed down significantly, has and is still expanding rapidly during this downturn!
4% doesn’t sound high to us, but on the CPI scale it starts to catch the attention of the central banks. To put this into perspective, a 5% CPI may translate into a 5-year fixed mortgage rate of 10% for us. This is not to say that is exactly what I think the numbers will look like in relation to CPI, but just to illustrate that the numbers do not correspond linearly or one to one. Be aware of such a difference.
What Should We Do?
The investor, business owner, and average individual care about items that are both included, as well as excluded from the CPI basket (items related only to consumer purchases). Such items include personal income taxes, and costs of lending rates as well, not just user fees and items associated with the purchases of goods/services. In any case the government’s definition/method of calculating and measuring inflation is not adequate for us. We have a different use for measurements of inflation, and therefore must pay attention to other additional inflation metrics.
I tend to use additional metrics for my own gauge/measure of inflation, specifically factoring in changes to taxes, loan rates, real estate prices, new government services (paid through taxes), etc, as they affect me directly or my investments/business. However, I also look at the CPI and the central bank’s decisions, to remain informed as well as to plan based on the government’s behavior and potential policy moves.
Investors and individuals will benefit greatly (financially) by being aware that a difference exists when they hear the term “inflation” being used, and to decipher what is being referred to. They may mean very different things, that hold different implications.
Inflation is not a problem, or so it seems, at the moment. That does not mean one should be complacent about it. By the time it does become a problem (and I think it will be in a few years), it will be too late to take advantage of the relatively lower inflation and lending rates of today. Governments are generally reactive in nature, although in the last few years they have put in some efforts to being proactive as well. However individuals and businesses must be proactive rather than reactive, and not be caught off guard by pending future events (that can be determined today).
Articles On The Causes Of Upcoming High Inflation:
– Implications of The Federal Reserve’s Purchase of Treasuries
– How The Financial Crisis Will Affect The US Dollar, Inflation, Gold, and Oil Prices
– Q&A: Long Term vs Short Term Treasuries, Spread, The Fed, Interest Rates
Update: Title changed to better reflect the article’s content.
Thanks & Happy Investing! — The Investment Blogger © 2009