If you do not necessarily purchase an identical fixed basket of goods every year, then an inflation calculation based on the cost of a fixed basket of goods may be a misleading measure of how your cost of living has changed.
When the price of a good rises, consumers tend to purchase less of it and to seek out substitutes instead. Conversely, as the price of a good falls, people will tend to purchase more of it.
This pattern implies that goods with generally rising prices should tend over time to become less important in the overall basket of goods used to calculate inflation, while goods with falling prices should tend to become more important. If consumers were utterly inflexible in their demand for peaches, this would lead to a big rise in the price of food for consumers. Alternatively, imagine that people are utterly indifferent to whether they have peaches or other types of fruit.
Now, if peach prices rise, people completely switch to other fruit choices and the average price of food does not change at all. A fixed and unchanging basket of goods assumes that consumers are locked into buying exactly the same goods, regardless of price changes—not a very likely assumption. The other major problem in using a fixed basket of goods as the basis for calculating inflation is how to deal with the arrival of improved versions of older goods or altogether new goods.
It would clearly be misleading to count the entire resulting higher price as inflation, because the new price is being charged for a product of higher or at least different quality. Ideally, one would like to know how much of the higher price is due to the quality change, and how much of it is just a higher price.
The Bureau of Labor Statistics, which is responsible for the computation of the Consumer Price Index, must deal with these difficulties in adjusting for quality changes. Figure 1. How do you think this price compares with today? For example, the useful life of automobile tires increased substantially over the past few decades, decreasing the tire cost on a per mile basis, but the CPI does not reflect such improvements.
New product bias - new products are not introduced into the index until they become commonplace, so the dramatic price decreases often associated with new technology products are not reflected in the index. Outlet bias - the consumer shift to new outlets such as wholesale clubs and online retailers is not well-represented by the CPI. The U. Department of Labor has responded to these biases by more frequently changing the base period when the items in the index and their weights are adjusted.
So if improved surgical techniques reduce the length of a hospital stay, this will register as a price reduction even if the daily room rate remains the same.
It is estimated that this change, which represents a better method of measuring quality change in medical care, will shave up to 0. But are there other quality changes that are not accounted for? The Boskin report argues that the BLS misses many quality improvements; and it estimates that in recent years this has caused CPI inflation to be biased upward by 0.
This estimate is based on a category-by-category evaluation of each of the components of the index. However, although many of these evaluations are based on empirical data, others are derived from judgments that not everyone would agree with. For example, the report guesstimates that the greater variety of foods and beverages now available represents a quality improvement that introduces an annual bias of almost 0. BLS officials have argued that the quality bias is smaller than the Boskin Commission estimates.
They also argue that making bias adjustments on the basis of judgments that—although plausible—cannot be fully defended with statistical evidence would open the BLS to endless criticism and controversy and might undermine the credibility of the CPI and other BLS data, too Abraham Many of the estimates cited in the Boskin report came originally from this research.
Already a variety of changes are in train that will have the net effect of cutting almost half a percentage point off measured inflation by the end of the decade.
Nonetheless, there is significant uncertainty about the size of the remaining bias. But although we may be uncertain about its exact size, we can be pretty sure that the bias is not zero, but positive. Assuming that there is no bias until we are able to measure it precisely is a bad strategy because, in fact, we shall never be able to measure it precisely. As Chairman Greenspan argued recently—quoting Maynard Keynes—it is better to be roughly right than to be precisely wrong.
Boskin, Michael J. Toward a more Accurate Measure of the Cost of Living. Lebow, David E. Roberts, and David J. Federal Reserve Board. This publication is edited by Sam Zuckerman and Anita Todd.
Permission to reprint must be obtained in writing. As the inflation rate increases, higher nominal returns must be earned to obtain a desired real rate of return. The nominal annual required total return is approximated as the real required return plus the rate of inflation. For short investment horizons, the approximate method works well.
However, for longer investment horizons such as 20 years or more , a slightly different method should be used because the approximate method will introduce additional inaccuracy, which will compound as the investment horizon increases. A more accurate estimate of the nominal annual required total return is calculated as the product of one plus the annual inflation rate and one plus the required annual real rate of return.
The results in the table show that as the difference between the inflation rate and the real rate of return increases, the difference between the approximated and the accurately determined total required returns increases.
The effect of these differences is magnified as the investment horizon increases. The first-rate of return in each pair is the approximated return, and the second rate is more accurately determined.
The GDP is one of many economic indicators investors can use to gauge the growth rate and strength of an economy.
Governments also use CPI to set future expenditures. Many government expenses are based on the CPI and, therefore, any lowering of the CPI would have a significant effect on future government expenditures. A lower CPI provides at least two major benefits to the government:.
Many of the factors contributing to the CPI controversy are shrouded in complexities related to statistical methodology. Other major contributors to the controversy hinge on the definition of inflation and the fact that inflation must be measured by proxy. The BLS describes the CPI as a measure of the average change in the price of goods and services purchased by households over time on an average day-to-day basis. This framework means that the inflation rate indicated by the CPI reflects the changes in the cost of living or the cost of maintaining a fixed standard of living or quality of life.
In other words, it is a cost-of-living index. To illustrate a simplified example of the effect of the CPI on consumer behavior and its different calculation methodologies, assume the following scenario where substitution happens at the item level within a category in keeping with the BLS methodology.
Suppose that the only consumer good is beef. There are only two different cuts available - filet mignon FM and t-bone steak TS. A set of prices have been constructed to reflect this scenario and are presented in the table below. The CPI, or inflation, for this contrived scenario, is calculated as the increase in the cost of a constant quantity and quality of beef, or a fixed basket of goods.
This method is unaffected by whether consumers change their buying habits in response to a price increase. This result is identical to that obtained with the fixed basket method used by Williams.
The previous calculations showed that the CPI methodology used by the BLS, given the scenario and consumer behaviors described above, result in a CPI that depends on consumer behavior. Furthermore, an inflation level that is lower than an observed price increase can be measured. Although this example is contrived, similar effects in the real world are definitely within the realm of possibility.
Investors could use the official CPI numbers, accepting the government reported figures at face value. Alternatively, investors are faced with choosing either Williams' or Ranson's measure of inflation, implicitly accepting the argument that the officially reported figures are unreliable. Therefore, it is up to investors to become informed on the topic and take their own stance on the issue.
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