The Inflation Deflator

Today we're talking about the Inflation Deflator. 

The rate of inflation in the US, Canada, Europe and much of the industrialized world is reported by each respective central government. These statistics follow a methodology that is publicized, but highly complex and rather difficult to understand. The measure of price inflation is the consumer price index. In the good old days, the statisticians followed a simple process of comparing the price of a basket of goods over time. 

Over the years, governments have made small tweaks to the inflation adjustment. 

We’re being told today that inflation is very low, in fact worryingly low. Governments in Europe, the US and Canada have set a 2% target for inflation. But I’m not sure that governments are being fully truthful with the numbers they’re reporting. I’ll give you an example.

Most educated people would agree that there is a link between the price of energy and the cost of goods. From December 1 until today, the price of oil has gone up 39% in the past 5 months. Shockingly, the US Bureau of Labor and Statistics reported that inflation in Q1 was a stunning 0.9%.

This past week, I paid $6 for a bunch of celery. Yes, we are in the middle of spring. This is not the time to be harvesting celery. So it’s being shipped from a long way away. Much of our produce during these months comes from Mexico and South America. 

So the price of energy is a significant component of much of what we consume. So how is it that items like celery can cost $6 and yet the inflation index is running at 0.9%. It turns out there are numerous adjustments that the government applies. The first is the so-called seasonal adjustment. If prices are expected to fluctuate with the seasons, then those seasonal fluctuations are removed from the inflation number. 

1. Since many government costs like social security, hourly wages of government workers are tied to the rate of inflation, a lower reported rate of inflation means the government saves a ton of money
2. The measurement of gross domestic product is based on adding up all the economic activity in the economy and comparing it to the previous period. If the number is higher, then the economy is said to have grown. But in the presence of inflation, we would need to subtract the rate of inflation from the measurement of GDP. Otherwise we would have a false GDP measurement. So we take the nominal GDP measurement, subtract inflation, and we get the real GDP measurement. But if the inflation is understated, then the real GDP is overstated. Governments like to report economic growth. It’s one of the measures that they use to show the voting population how great a job they’re doing.  

There are several more adjustments applied by the statisticians in addition to the seasonal effects. The second is something called substitution. This is based on the concept that if the price of a Lexus goes up, consumers will switch to a cheaper Toyota.

The third is the concept of imputation. This is where there is no actual economic activity. So the Bureau of Labor and Statistics assigns a value to the contribution to the economy, even though no money changed hands. The largest and most questionable of these measures is the concept of imputed rent. If you own your own home and do not rent, the government adds in the value of the rent that you should have paid if you were renting.

The fourth sleight of hand is in fact weighting. This is where they determine how much of the CPI should be attributed to each part of the household expenditures. Today, healthcare makes up about 8% of the consumer price index. But healthcare actually makes up closer to 18% of the US economy.

The final and most outrageous adjustment is hedonics. These are the arbitrary price adjustments the government make to suit their rationale.