Friday, September 18, 2009

CPI vs. GDP Deflator

As a holder of Treasury Inflation Protected Securities (TIPS), I have a vested interest in tracking the Consumer Price Index (CPI) and understanding how it can affect me.

The CPI is something I understand and for the most part I am comfortable with how it is calculated (as it relates to my investments anyway).

The GDP Deflator is something I did not understand so last night I attempted to better educate myself.

Measuring the Economy 2

The CPI uses a fixed basked of goods from some base year, meaning that the quantities of goods and services consumed remains the same from year to year in the eyes of the CPI, whereas the price of goods and services changes.

The GDP deflator, on the other hand, uses a flexible basket of goods that depends on the quantities of goods and services produced within a given year, while the prices of the goods are fixed.

Generally speaking, the two indexes track each other fairly closely. The article offers an example showing how an extraordinary event can cause the two indexes to vary widely though. I'm going to offer my own example so that I can plug in actual numbers.

Let's say the basket of goods consists of exactly two items to make things simple. The first product is a six-pack of Coca Cola. The second product is a six-pack of Pepsi.

Let's say each product costs $2 and therefore our basket of goods costs $4.

Now we'll add an extraordinary event. The Great Depression sets in. Pepsi goes out of business. Meanwhile, Coca Cola has to cut prices in order to get people to drink soda over water.

In one year it costs $1 for the six-pack of Coca Cola but it costs $99 for a six-pack of Pepsi (if you can even find one).

Under the CPI model, your basket of goods would now cost $100. That's a 25 times increase in the price of your goods. That's hyperinflation!

Under the GDP deflator model, your basket of goods would now only cost $2. You would have substituted entirely to Coca Cola. Rather than have one six-pack of each, you'd now have two six-packs of Coca Cola. That's serious deflation! What once cost you $4 now only costs you $2.

So what is the truth? It depends. If Coca Cola is your life and the thought of drinking Pepsi upsets you anyway, then your standard of living will rise substantially. If Pepsi is your life and the thought of drinking Coca Cola upsets you, then you will most certainly experience a massive price increase and/or a dramatically lower standard of living.

As far as our Gross Domestic Product is concerned, it's deflation. Everyone would assume to have substituted to Coca Cola. Pepsi went out of business. Hello deflationary spiral. Hello Great Depression.

As far as the CPI is concerned, we've entered hyperinflation. Clearly we haven't really entered hyperinflation though. Most rational consumers would substitute.

So when you see people get all bent out of shape talking about the bogus CPI and how substitution is a conspiracy and a fraud, you may wish to think twice. We really do substitute. Without that substitution, the CPI really does overstate inflation. Further, very few substitution adjustments have been added to the CPI. I substitute a LOT more than it thinks I do.

I substitute all the time. If something becomes more expensive, I'm very likely to buy less of it. If something becomes less expensive, I'm very likely to buy more of it.

CPI Explained – Part 2 – Substitution

To summarize, consumer substitution is a sign of inflation. BLS has been convinced by politicians to use consumer substitution as justification for removing inflation from inflation. Huh? So the CPI is a way to measure inflation (rising prices) without equal mathematical weighting for items that are rising rapidly in price.

That is utter BS. While we do substitute away from items rising in price (so that part is right), we also substitute towards items falling in price (which he has conveniently ignored). Substitution therefore isn't a sign of inflation or deflation. When substitution appears, it simply means that all prices are not rising or falling uniformly.

The lack of substitution adjustments will always make inflation appear to be higher than it really is. Hopefully you can see that in my example. Without substitution adjustments, all it takes is the price of one product in the CPI to move to infinity and the entire index would move to infinity right along with it. For some products where no substitution is possible, that's a rational outcome. However, if the price of Pepsi (but not Coca Cola) became infinitely expensive tomorrow, my budget would not be infinitely doomed.

10 comments:

EconomicDisconnect said...

Mark,
I am going to be busy tonight as my Mom has need of me after a hospital stay, but I wanted to chime in here.
Your example is very good, and it shows how substution is a needed componet, otherwise, yes soda hyperinflation!
Still, I am one of the lunatics that deem the CPI, as reported, as silly and manipulated as to hide inflation. Think hedonic adjustments, the use of rents (CPI would have been over 10% for 3 years running using home prices, maybe now they switch as home prices are falling!), and yes even substitution (if steak goes up in price, consumer switches to chicken = no inflation), health care and college costs are also vastly underrated.
You may be right, and I may be crazy.

Stagflationary Mark said...

GYSC,

Hedonic adjustments...

If something really is twice as good then it really should cost twice as much. That can be a bit subjective though and therefore hard to prove one way or another. Of course, not being able to prove something is the very basis of a good conspiracy theory.

The use of rents...

During the recession in the early 1990s people complained that the CPI was understating inflation just as they were recently. When housing prices fell people were complaining that the CPI was overstating inflation. These days though, many people seem locked into the idea that the CPI always understates inflation. I find that laughable. Our economy has experienced a severe deflationary crash and the CPI does not adequately show the deflationary impact (due to rents not falling as fast).

IF the government was to change the CPI to reflect housing prices directly THEN I would still only partially agree with you. Why? The horses are already out of the barn. The prices have already crashed. It is too late! If the government was truly that evil, then it should have changed the model as prices were just starting to come down. They didn't. Just like they didn't during the recession in the early 1990s.

Housing prices and rents SHOULD track each other over the long-term. That's why I do not have a problem with owner equivalent rents as it applies to my investments. That said, I think that sheltering the CPI from the housing bubble in order to smooth out the trend was a mistake. It allowed the bubble to be that much more frothy before it collapsed.

Substitution...

I've covered that here. I will add this about the chicken and beef debate though. If beef skyrockets in price and its simply because of inflation, then the price of chicken should skyrocket in price too as people substitute. Just think of the supply and demand for chicken. It would be blown completely out of the water. Just something to think about. On the other hand, if beef explodes in price simply because there is something going on with beef (sick cattle), then perhaps it really isn't all that inflationary. In other words, if there really is an inflation problem, then inflation WOULD trickle over into chicken prices.

The government is not trying to claim that since people are switching from $10 steak to $2 chicken that there is a -80% inflation rate. That's why people get so emotional about it though. The goverment is claiming that if $10 worth of chicken is not rising in price as fast as $10 worth of beef then some people will switch to chicken. See my point? The market sets the relative value of the products. Clearly the market thinks $10 worth of chicken is worth EXACTLY the same as $10 worth of beef. In the market's eyes, both chicken and beef are therefore identical.

"Health care and college costs..."

Unfortunately, these costs vary widely depending on the person. No inflation index can be perfect. For example, I have had ZERO college costs in the last 22 years. I'm therefore dragging down their relative importance in the CPI.

Exploding health care costs would not affect a person such as Warren Buffett much, since health care is such a tiny, tiny fraction of how he spends his money. On the other end of the extreme, we know exactly how much risinig health care costs are hurting the poor though. That's VERY unfortunate. I would therefore argue that part of the problem you have with the CPI might be better focused on this country's widening income inequality. That's a very serious problem. The 10% richest people are spending in ways that the poorest cannot, and unfortunately the CPI has no way to compensate for it. As far as the CPI goes, the average person spends what the average person spends.

Stagflationary Mark said...

One more thought (my comment was too long).

I will also add one more thing for you to consider and that is how the CPI deals with new technology.

The CPI is composed of a fixed basket of goods. When the Playstation 3 came out a year or two ago, it was more than likely not in the index. Right? I paid $399. I thought it was a fair price at the time. People can now buy it for $299. How much deflation will the CPI miss because the government is simply too slow to get new items into the index in a timely manner?

Stagflationary Mark said...

I can't seem to stop, lol.

Why do people offering the substitution conspiracy theory always assume that people will be switching from steak to chicken? I'm not picking on you though. Everyone does it.

If the price of chicken went up faster than the price of steak, then the government would assume that more people would switch to steak (even though steak is generally more expensive). That doesn't make the argument quite as convincing though. Does it?

Let's say chicken costs $2 and steak costs $4. I would then tend to eat more chicken. I do like steak more than I like chicken, but not twice as much.

However, if the price of chicken rises 50 cents (to $2.50) and the price of steak drops 50 cents (to $3.50) then I would probably start eating more steak.

It's unfortunate that the chicken vs. steak arguments are intended to pull at our emotional heartstrings. What we really need more of is just cold honest truth (from all sides).

The emotional heartstring pulling is really hitting home in the health care debates right now. As you know, there is no way for the government to magically create free health care for all of us (even with a monetary printing press, hahaha!). We've been spoiled by never ending "free lunches". We want it all, we want it now, and we always want someone else to pay for it. Unfortunately, I think we've already bankrupted the usual suspects (our children and grandchildren).

EconomicDisconnect said...

Mark,
after a long night all I can say is this debate has plenty of room for, well, debate!
I would say we agree mostly, with some differences, but that makes the world go round.
The chicken/beef issue is an example that is overly simplified.
I will close with this thought: If the CPI is how SS benefits are indexed, money supply is metered out, and other inflation adjusted payouts are calculated, do you think a high reading will be in the best interest of the calculators?

Stagflationary Mark said...

GYSC,

"...do you think a high reading will be in the best interest of the calculators?"

Of course not! Fortunately, some bean counters have ethics and fortunately government bean counters are neither elected nor do they profit off of small differences in milk prices.

In other words, I don't inherently distrust all government employees, especially those at the bean counting level.

That said, if you were to tell me that CPI calculations were to be outsourced to Wall Street I'd be selling all my CPI-linked TIPS for a loss no doubt. I'd probably have serious difficulty finding a greater fool to buy them from me!

Take David Walker. He was what I would call a chief bean counter.

http://en.wikipedia.org/wiki/David_M._Walker_%28U.S._Comptroller_General%29

"Walker has compared the present-day United States with the Roman Empire in its decline, saying the U.S. government is on a "burning platform" of unsustainable policies and practices with fiscal deficits, expensive overcommitments to government provided health care, swelling Medicare costs, the enormous expense of a prospective universal health care system, immigration, and overseas military commitments threatening a crisis if action is not taken soon."

Pretty bold for a government bean counter. That's the kind of thing I would say.

http://en.wikipedia.org/wiki/Government_Accountability_Office

"The GAO is headed by the Comptroller General of the United States, a professional and non-partisan position in the U.S. government. The Comptroller General is appointed by the President, by and with the advice and consent of the Senate, for a 15-year, non-renewable term."

How could he offer the truth? Job security. Perhaps one reason I am somewhat forgiving of some in government is based on my enjoyment of the British TV series called "Yes, Minister".

It is and was a VERY funny look into politics. There are the politicians who think they run the show. Then there are the long-term civil servants who actually run the show.

http://www.youtube.com/watch?v=jNKjShmHw7s

By the way, right or wrong, Bernanke is running the show. I clearly don't always agree with him. I often heckle him. I don't really question his ethics all that much though. I honestly think he is trying to help our country. I am very thankful that although he has to play politics, at least he's not a pure politician. We could be doing worse.

EconomicDisconnect said...

Mark,
I give up! Inflation should only be reported in 50 year intervals, that way it "smoothes the data". CPI from 1950-2000 I am sure averages 1-2% or whatever. Unless you had to live through the late 70's into the early 80's, sure inflation was no worry! You win. Inflation is and always has been nonexistent.

On a more serious note, my mother is at that age where if things can go wrong, they will, and there was a pretty serious setback tonight. I will be trolling blogs for a bit to try and stay distracted, and I thank you for your always fun back and forth.
My word verification is:
rehmetan
Thats just not fair!

Stagflationary Mark said...

GYSC,

I'm really sorry that your mom had a serious setback tonight. It's tough when those around us have health issues. Hang in there.

EconomicDisconnect said...

Thanks Mark.
This morning things are very encouraging, so we are all thankful. You know, the class they should have you take in college instead of "Philosophy 101" is a real world class maybe named "You and everyone around you will get old and have problems; how to deal with that eventuality".!
Thanks again for the kind words.

Stagflationary Mark said...

GYSC,

That's good news!

Hey, if we don't take Philosophy 101 then we can ALL become economists. None of us will be able to answer the "why" you mentioned on your website.

Debate! It's not just for breakfast any more. Hahaha! :)