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Jul 27

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Another way of measuring inflation…

Americans are continuing to feel their wallets pinched at gas and food stores (among other places).   Why are these feelings so widespread when the inflation rate appears to be still relatively low?   Shockingly (or maybe not so much), the answer lies in government statistics.  The Federal Reserve generally focuses on the “core” Consumer Price Index (CPI).  The core CPI ignores food and energy prices, both of which have been continually increasing more rapidly than other prices.  A recent article details how inflation (and the risk that inflation will increase), is a far greater problem than the Federal Reserve admits.    Among other reasons, the CPI is important because it is used by the Federal Reserve to justify its monetary policy.

According to the Bureau of Labor Statistics (BLS),

…the 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.

Thus, the CPI is designed to measure the cost of a fixed basket of goods, comparing apples to apples to accurately measure (i) returns on investments relative to inflation, and (ii) the standard of living one can afford on a given income relative to inflation.   However, since the late 1970s, the BLS changed how it measures the CPI “basket” 24 times.

By substituting product and quality improvements, the inflation rate can be artificially decreased.  For example, if the price of steak increased “too much”, the price of hamburger or something “comparable” would be substituted into the CPI.  As a result, the CPI has changed from measuring inflation relative to a given standard of living to measuring inflation relative to a declining standard of living.   A chart shown in the recent article shows that if the original methods (those prior to the late 1970’s) were still used today, today’s CPI would be approximately 10 percent, significantly higher than current inflation rate measurements.   Not only is inflation underestimated because BLS changes its basket of goods to stay away from expensive items, but there is a significant lag from the time the inflation data is recorded and when it is released to the public.  

It appears others have not only picked up this significant flaw of the current inflation measure, but have also actually developed other means of measuring inflation that may be both (i) a more accurate inflation measure, and (ii) a more timely measure.    Two economists at MIT created the Billion Prices Project (BPP) that collects prices from hundreds of online retailers around the world on a daily basis to (among other things) calculate U.S. inflation rates.

According to the website,

Methodology

Data collection: our data are collected every day from online retailers using a software that scans the underlying code in public webpages and stores the relevant price information in a database. The resulting dataset contains daily prices on the full array of products sold by these retailers. Our data include information on product descriptions, package sizes, brands, special characteristics (e.g. “organic”), and whether the item is on sale or price control.

Daily Online Price Index Computation: The daily online index is an average of individual price changes across multiple categories and retailers. The index uses a basket of goods that changes over time as products appear and disappear from a retailer’s webpage. It is updated on a daily basis and leveraged to estimate annual and monthly inflation. This index is not designed to forecast official inflation announcements, but to provide real-time information on major inflation trends.

The BPP’s inflation measure differs from he government’s measure in essentially three ways.

  1. BPP averages online prices – the “basket of goods” is whatever one can purchase on the internet.  
  2. BPP does not weight a particular item’s price more than another even if it comprises a larger proportion of household spending or if the item’s price is higher than a comparable items’ price.
  3. BPP’s index is published daily, providing a more efficient indicator of inflation’s direction. 

A practical example of this is when Lehman Brothers collapsed in September 2008 and online retailers almost instantly slashed prices. The BPP index declined significantly, while official inflation figures failed to show a decline until a month later.  Despite the above advantages the BPP index may have over the government’s index, BPP index still has its downfalls.  On BPP’s website, it articulates some of these.

These indexes are designed to provide real-time information on major inflation trends, not to forecast official inflation announcements. We are constantly adding new categories of goods, but we do not cover 100% of CPI goods and services. The price of services, in particular, are not easy to find online and therefore are not included in our statistics.

Because BPP index only comprises retail prices, it uses a proxy to measure service prices.   For example,  BPP calculates health-care costs by weighting changes in the price of wages, energy and drugs. Despite these downfalls, the fact that others are not merely recognizing the governement’s data pitfalls, but are actually creating an viable alternative is all good news in my opinion.

About the author

Nicole Liska

I am a Principal at Fulcrum Inquiry, an accounting and economic consulting firm that performs damage analysis for commercial litigation, forensic accountings, financial investigations, and business valuations. I hold an ABD and MA in economics from the University of California, San Diego. I perform damages analyses and serve as a damages expert witness. My resume is on Fulcrum's website.

Permanent link to this article: http://betweenthenumbers.net/2011/07/another-way-of-measuring-inflation/

1 comment

  1. Silva

    Superb facts! I have been looking for something similar to this for a time now. Appreciate it!

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