Why Inflation Is Lower Than You Think

by Robert Huebscher, AdvisorPerspectives.com

Financial pundits routinely claim that inflation is much higher than the reported statistics. We hear, for example, that food prices have risen much faster than the roughly 1.5% increase in the consumer price index (CPI) over the past several years. Viewed over the longer term, however, inflation is far lower than reflected in the published data.

The reason for this anomaly is that the CPI doesn’t reflect the rapid advances in technology and the new products and services that have benefited everyone.

The implications are profound. For example, real GDP growth is greater than has been reported, and some claims of income inequality are misleading.

This theme was the focus of two recent presentations I attended. On October 18, the economist Woody Brock hosted a private gathering of investment professionals from Australia and New Zealand, organized by the Portfolio Construction Forum, at his home in Gloucester, Massachusetts. On October 22, Rick Rieder, the CIO of fundamental fixed income at BlackRock, spoke at the CFA Institute Fixed-Income Conference in Boston.

Let’s look at the distortions in the reported inflation statistics and the implications they have for policymakers.

The problems with the CPI and PCE

The CPI, which is administered by the Bureau of Labor and Statistics (BLS), and the personal consumption expenditure (PCE) index, which is the Fed’s preferred metric for measuring inflation, rely on tracking the prices of a basket of consumer goods. Those goods include food, clothing, energy and housing, which is the largest component of both indices.

They differ in that the CPI maintains mostly fixed weightings, whereas weightings in the PCE are adjusted over time. The PCE also incorporates “chained weighting” adjustments; it assumes, for example, that if the price of beef increases rapidly, then consumers will adjust their tastes and purchase less. As a result of the difference in weightings, over time the PCE typically reports lower inflation than the CPI.