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.