I used to speak of the inflation adjustments by our government often in 2007 and 2008 but chose to stop beating a dead horse.   However in the past few years FMMF has added a lot of new readers, so for 'educational' purposes it probably makes sense to review this topic since it has been a year and a half since I've devoted any air space to the topic and it is becoming increasingly relevant again, as many people feel like there is inflation, when the government insists there is none.  To repeat, inflation is not the only government statistic that the politicos have pressured our governmental statisticians to 'adjust' over the years, to make them more sunny side up  [Apr 23, 2008: Barry Ritholtz on Disappearing Economic Indicators].  [May 10, 2008: Finally Some Mainstream Reports are Figuring Out the Spin from Government] - but let's focus on that one as the Fed believes as long as there is no inflation it can QE and 0% Fed Funds rate to the moon, with no impact.

Shadowstats.com is a website I found long before I started FMMF, as a lot of things the government reported just did not pass the smell test.  It's actually a small treasure trove for anyone of an analytic mindset and when you really dig into all the changes in government reporting (under the guise of 'improvement' of course) over the past few decades in multiple reports it is quite awe inspiring.   Specific to inflation this entry from 2004 is a compelling read for any interested in the topic.

Before we continue, if you think this commentary is from sort of sensationalist random blogger type, let me point you to the fact that the biggest bond investor in the U.S. and one of the most powerful men in the investing world - PIMCO's Bill Gross - puts forward all the same arguments I do.  [May 13, 2008: News of the Day - Inflation]

Americans are feeling a lot more economic pain than the government's official statistics would lead you to believe, according to a growing number of experts. They argue that figures on unemployment and inflation are being understated by the government.

Bill Gross, the manager of Pimco Total Return, the nation's largest bond fund, refers to the CPI as a con job that deliberately understates the price pressures faced by Americans in order to keep Social Security payments and other government costs pegged to the index unduly low.

And.... [May 22, 2008: Bill Gross - Inflation Underplayed]

Americans are fooling themselves if they think U.S. inflation is under control, the manager of the world's largest bond fund said.  Bill Gross, chief investment officer of Pacific Investment Management Co (PIMCO) said in his June investment outlook that he has been arguing for some time that inflation statistics were not reflecting reality at the checkout counter.


He said statistical practices in calculating price growth had favored lower U.S. inflation over the last 25 years and called for change. Being fooled some of the time is no sin, but being fooled all of the time is intolerable, Gross said.


Join me in lobbying for change in U.S. leadership, the attitude of its citizenry, and (to the point of this Outlook) the market's assumption of low relative U.S. inflation in comparison to our global competitors.

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There are 2 main ways that our measurement of inflation has changed over the years - (a) substitution and (b) hedonic adjustments.  I explained the substitution effect in one of the 2008 pieces

put simply when the cost of steaks gets too high they assume you move down to hamburger - so they substitute steaks for hamburger in their measure (seriously) and hence inflation disappears. So in the government's eyes we are going to be a world of bicycle riding, barefoot, and beltless (or using string to keep pants us) people. Because otherwise, inflation would go up.

Now to be fair, when prices go up people in the middle and lower economic classes DO substitute - they have little choice.  But that does mean inflation has gone down - a constant basket of goods would compare apples to apples - steak in 1956 vs steak in 1978 v steak in 2007.  Instead we measure steak in 1956 v hamburger in 1978 v SPAM in 2007. i.e. as prices go up the average American is moving downward in living standard.... but it keeps government inflation in check.  I'm using meats as the example since it is easy to see the move down the (excuse the pun) food chain, [Meat Inflation Picking Up] but it applies to many other subsectors.  I think anyone with a shred of common sense (thankfully, this excludes much of the federal government) would say you need to measure a movie ticket in from 50 years ago with a movie ticket from 25 years ago to a movie ticket from 5 years ago to measure inflation.  Granted, we can replace a movie ticket with a walk in the part (free!) and say there is no inflation at all, but most would laugh at that sort of 'analysis'... but that's the substitution effect!

Here is how shadowstats explains substitution (the writer explains the political history behind the changes as well, which I am skipping here)

  • Up until the Boskin/Greenspan agendum surfaced, the CPI was measured using the costs of a fixed basket of goods, a fairly simple and straightforward concept. The identical basket of goods would be priced at prevailing market costs for each period, and the period-to-period change in the cost of that market basket represented the rate of inflation in terms of maintaining a constant standard of living.  
  • The Boskin. Of course, replacing hamburger for steak in the calculations would reduce the inflation rate, but it represented the rate of inflation in terms of maintaining a declining standard of living. Cost of living was being replaced by the cost of survival. The old system told you how much you had to increase your income in order to keep buying steak. The new system promised you hamburger, and then dog food, perhaps, after that. 
  • The Boskin/Greenspan concept violated the intent and common usage of the inflation index. The CPI was considered sacrosanct within the Department of Labor, given the number of contractual relationships that were anchored to it. The CPI was one number that never was to be revised, given its widespread usage. 

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Hedonic adjustments is a bit tougher to explain - and if you laugh at how substitution works you will really get a chuckle out of hedonics.  Per shadowstats:

  • Aside from the changed weighting, the average person also tends to sense higher inflation than is reported by the BLS, because of hedonics, as in hedonism. Hedonics adjusts the prices of goods for the increased pleasure the consumer derives from them. 
  • That new washing machine you bought did not cost you 20% more than it would have cost you last year, because you got an offsetting 20% increase in the pleasure you derive from pushing its new electronic control buttons instead of turning that old noisy dial, according to the BLS
  • When gasoline rises 10 cents per gallon because of a federally mandated gasoline additive, the increased gasoline cost does not contribute to inflation. Instead, the 10 cents is eliminated from the CPI because of the offsetting hedonic thrills the consumer gets from breathing cleaner air. The same principle applies to federally mandated safety features in automobiles.  

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Ok time to pick yourself up off the floor - your co-workers are wondering what is so funny.  See economics is NOT that boring when the government is involved!  This is why I say, while the Chinese prefer to use straight out obfuscation to lie about adjust their government statistics, the U.S. is far more sly.  But the end result is the same - a fairy tale that is disconnected from what people feel on the ground.

So what's the takeaway?  We live in a world of no inflation per the government - see yesterday's 0.1% CPI figure!  It's a miracle.   More QE please!

But what happens when we detach one arm from the matrix and look at how inflation was measured in 1990?  Uh oh - not so rosy - inflation seems to be a bit over 4%.

[click to enlarge any chart]

And if we remove our whole body, Neo style?  Rut roh raggy!

I only bring you this message of course for education and entertainment;  for stock market purposes, there is no inflation - we live in a Goldilocks environment of government steroid growth and no inflation.  To make sure we get inflation QE2 and 0% Fed fund rates are a must.  And after QE2, we have QE3 thru QE9 ready because we *REALLY* need to get some inflation going. 

Back to your regularly scheduled market melt up....