SPEAKING
FREELY Caution: Inflation is higher than
you think By W Joseph Stroupe
Speaking Freely is an Asia Times
Online feature that allows guest writers to have
their say. Please click hereif you are interested in
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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 hereif you are interested in
contributing.
