How reliable is the CPI?

Can any single measure track consumer prices, cost of living and inflation?

By InvestorPlace Nov 3, 2010 1:45PM
Food inflation © Tetra Images/CorbisBy Ron DeLegge, ETFguide.com

Exchange Traded Funds and indexes have been hot topics of discussion lately, and today is no different.

Each day business, investment and policy decisions are made using the CPI. Even payments for Treasury Inflation Protected Securities are linked to CPI numbers along with Social Security benefits. But how reliable of a gauge is it?


As one of the most widely quoted economic indicators, there’s still a lot of confusion surrounding the consumer price index or CPI. Therefore, let’s analyze it.


Which CPI are we talkin' about?


The CPI’s annual percentage change is used as a barometer of inflation. The Bureau of Labor Statistics (BLS) defines the CPI as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”


CPI data covers two main population groups: 1) the CPI for Urban Wage Earners and Clerical Workers (CPI-W) and 2) the CPI for All Urban Consumers (CPI-U).


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CPI-W covers households of wage earners and clerical workers that comprise approximately 32% of the total population.


CPI-U covers approximately 87% of the total population and include in addition to the formerly mentioned workers, other groups such as professional, managerial, and technical workers along with self-employed, short-term workers, retirees and those not in the labor force.


Beyond this, there are many other CPI data sets which we won’t discuss to avoid falling asleep.


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Social Security and the "other" CPI


Many retirees are angry about no increases in their Social Security benefits. But what they don’t realize is that benefits are based upon changes in the CPI-W. And because the CPI-W hasn’t increased, neither will their Social Security payments.


One argument against linking CPI-W to Social Security benefits is that the buying habits of the typical retiree are drastically different compared to the average worker. For instance, medical care takes up a larger portion of total expenditures for seniors than younger workers.


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Interestingly, since the early 1980s, the BLS has calculated a consumer price index for elderly consumers but they’ve never used it to adjust Social Security benefits. Several unsuccessful congressional bills have been attempted to use this index.


Treasury Inflation Protected Securities (TIPS)


TIPS are government securities whose principal is tied to the non-seasonally adjusted CPI-U. With inflation, the principal increases. With deflation, it decreases.


Last year was the first time since 1955 the Consumer Price Index fell. And while that’s signaling tame inflation over the past year, the performance of TIPS exchange traded funds has been strong mainly due to falling interesting rates. TIPS ETFs have increased in value by around +9.7% year-to-date.


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TIPS pay interest every six months, based on a fixed rate applied to the adjusted principal. When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater.


CPI Faults


While the CPI is the U.S. government’s way of benchmarking the cost of living for consumers, it has its shortcomings.


For example, Core CPI calculations purposely exclude food and energy prices. According to the BLS, food and energy costs are volatile, which would potentially distort Core CPI readings therefore they’re omitted. However, to the average consumer who regularly buys these items, Core CPI is hardly an accurate reflection of inflation when it hits them in the wallet.


Personally, I think CPI statistics should include the rising cost of dog grooming. In New York City alone, average dog grooming rates have jumped 40% from $85 to $120!


The CPI also incorporates fantasy land concepts like “product substitution.” In other words, if the cost of grade “A” milk soars, statisticians substitute lower grade milk in its place.


Likewise, cost increases don’t count if the level of increased quality is deemed better. Here’s how that works: If taxi cab fares triple, but taxi transit is considered to be three times as efficient, the calculated cost of taxi travel remains unchanged. And the problems with CPI don’t end there because it underweights medical and insurance costs which are both huge financial burdens for the typical citizen.


“In fairness, much of what has become distorted in the CPI series has resulted from pressures outside of the Bureau itself, ranging from the perceived political needs of overseeing administrations, to Congress and the Federal Reserve,” states John Williams, economist and publisher of ShadowStats.com.


In recent years, others have adopted the view the CPI should be a cost of living index or COLI. But even in its attempt to benchmark the cost of maintaining a constant standard of living it comes up short, which brings us back to square one: Is there really any single measure that can accurately track consumer prices, the cost of living and true inflation?


The answer is probably not.


For more ETF research and ETF information, follow these links.


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1Comment
Nov 3, 2010 7:47PM
avatar
There was a great book in years gone by, "How to Lie with Statistics." The CPI is a great example of this; if things are too volatile or will "throw it off," then just don't include them in the calculation, even though everybody I talk to says that the CPI is a joke, precisely because it doesn't take these things into account. A great way for our government to lie to us.
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