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     Jun 27, 2006
Caution: Inflation is higher than you think
By W Joseph Stroupe

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In response to the criticisms of politically powerful opponents who had a vested interest in a low officially reported and accepted rate for inflation, the transparent and relatively simple Consumer Price Index (CPI) calculation of the inflation-ravaged 1970s and 1980s has evolved into something much more complex that has an array of built-in facilities for moderating the effects of higher prices, those considered and labeled "volatile".

These changes have certainly not resulted in the reporting of higher numbers for inflation, but precisely the opposite. Are the

resulting numbers truly representative of the real inflationary picture, or are they merely what government prefers consumers and the markets to believe?

Until the early 1990s, the CPI was a straightforward calculation using the costs of a fixed basket of goods. The identical basket of goods was priced according to prevailing market prices from period to period and the acceleration or deceleration in price represented the rate of inflation for the period. Consequently, this relatively simple calculation served to represent more correctly the costs of maintaining a constant standard of living as prices increased because of inflation.

However, in the early 1990s that transparent method of CPI calculation came under assault from Michael Boskin, then chief economist to the administration of US president George H W Bush, and Alan Greenspan, then chairman of the board of governors of the Federal Reserve System.

Their assertion was that the CPI calculation was much too simplistic and resulted in much too high a measure of inflation. They argued that the calculation needed to take into account the real-world phenomenon of substitution, whereby consumers who cannot afford more expensive items switch to buying the less expensive ones, and that the inflation calculation should switch to tracking the costs of the less expensive items whenever substitution was presumed to occur.

That generally would have required moving from the fixed basket of goods to a variable one, but initially, instead of that move the concept of weighting was introduced into the fixed basket in an effort to approximate the phenomenon of substitution.

Straight arithmetic weighting was gradually replaced by geometric weighting by 1999. In the geometric weighting favored by Boskin and Greenspan, the basket items with recently increasing ("volatile") prices receive less weight while those that decrease in price receive more weight. So the result is a lower overall number for inflation.

It must be noted that the Boskin Commission forcefully presented the case for geometric weighting of the basket items to account for what it clearly saw as the powerful phenomenon of substitution, consumer-switching from more expensive to less expensive items. While the commission focused primarily on the need for changes in the calculation to account "properly" for substitution, its preoccupation with substitution is an admission that substitution is in fact a major factor. Since, in the absence of significant price inflation, consumers would be unlikely to engage in substitution on a meaningful scale, then it is also an indirect but powerful admission that significant price inflation does exist, for why else would consumers switch from more expensive items to less expensive ones?

Thus, by and large, the technical efforts aimed at accounting for substitution in the CPI calculation have diverted attention from the reality of mounting price inflation to the side issue of how consumers are being forced to deal with it.

Another change that has been introduced into the CPI calculation is the use of "hedonics". Hedonics seeks to moderate or account for higher prices by taking into account the increased "pleasure" or satisfaction the consumer derives from a more expensive but supposedly more satisfying product. The introduction of hedonics also has a net effect of lowering the inflation number because the weight of many price increases tends to be nullified in the calculation. However, the attempt to "price down" a more expensive item because it has a higher quality or more features than a reference item is largely subjective, for what is the standard to determine exactly how much the additional quality or features are worth and thus how far down the price effects should be brought?

Very importantly, because of all such changes in the CPI calculation the resulting number for inflation that is reported by government no longer represents the actual costs of maintaining a constant standard of living, as it did in the 1970s and 1980s. Instead, the number more closely represents the costs of holding to an ever declining standard of living.

Thus, critics credibly charge, the official CPI significantly distorts real inflation in the downward direction, making it look much less threatening than it actually is in the real world. Increasingly, and for very good reasons, the man on the street in the United States doesn't buy the official comparatively low 3% core and 5% combined rates of inflation.

As for the number reported for the core rate of inflation, which is arrived at by subtracting out energy and food prices, that number is still achieved using the methods noted above. The core rate calculation seeks to identify whether food and energy prices are having a pass-through inflationary effect upon the rest of the economy.

But since there exist within the calculation a number of factors (as noted above) that all tend to depress the inflation measure, the core measure possesses a distinct sluggishness in representing any pass-through pressures. The core inflation measure is understated and lags significantly behind reality, therefore. What it currently portrays is not commensurate with today's real inflation picture, but rather, at best, with that of many months to a few years ago.

The June 16 comments of Federal Open Market Committee (FOMC) member William Poole, speaking in South Korea, are a warning to the Fed in this regard. He warned that the "formal data" may not be portraying the full inflationary picture, which he says may be worse than the Fed thinks.

The US government has powerful motives for significantly understating the rate of inflation, and knowing that blind trust in whatever it says is foolhardy, a brief examination of its motives is certainly appropriate.

First, US entitlement payments such as Social Security and Medicare are tied to the official CPI. Cost-of-living increases in such payments would seriously balloon the deficit if the official CPI calculation were allowed to revert to its more transparent form. The economic and political ramifications would be enormous.

Second, the Fed is intent on doing all it can to shape inflationary expectations, and the new non-transparent official CPI is a great aid in that effort because it portrays inflation as "not dangerous at all". The official CPI has been a powerful way to lower and to shape inflationary expectations until now.

However, if the Fed really believes its own official CPI, then it is likely to make a huge strategic error and fall behind in the fight against inflation. The official CPI is intended for public consumption only. FOMC members should regard it with suspicion.

The stakes are enormous now as the US economy simultaneously faces slowing growth and mounting inflation, the kind of impending downturn that is making the big Asian economies, Russia, Central Asia and the Middle East think twice about the desirability of continued US global economic leadership. If Washington stumbles in the fight against inflation, either by letting it get out of control or by killing economic growth as it tries to suppress it, the US government may find that the rest of the world's economies won't simply continue to look for solutions and their future fortunes within the framework of the old US-centered global economic order.

With the noteworthy rise of an ever more powerful Asian economic bloc, the simultaneous rise of Russia and the deepening cooperation of all such players and their growing list of oil- and gas-exporting partners in the energy and economic spheres, the old US-centric order is already set to come unglued. The impending US economic downturn, one likely to involve a heavy dose of stagflation along with significant and lasting pain, may be the catalyst that causes the global economic compass finally to swing fully eastward to Eurasia as the new global economic center of power.

W Joseph Stroupe is editor of Global Events magazine at GeoStrategyMap.com, a publication specializing in strategic analysis and forecasting. He is writing a book, New World Order: Multi-Polarity or Asymm-Plexity? with the subtitle The Impending Birth of an Asymmetrical Bi-Polar World Order Characterized by the West under Energy-Based Checkmate by Multifarious East, due for completion late this summer.

(Copyright 2004-06 GeoStrategyMap.com and W Joseph Stroupe. Used by permission.)

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.

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