What is inflation? According to the Merriam-Webster dictionary, it is a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services. This makes sense if we look to the Boise real estate market, where demand (money) is exceeding the supply of new housing, resulting in higher prices.
The current definition of inflation has become amorphous. Why measure inflation at all? As consumers we need to have wages rise at the rate of the prices of the goods and services we consume, lest our standard of living decline. Therefore, to consumers, the best measure of inflation is one that accurately portrays the increased cost year over year to maintain the current standard of living.
Do current widely used measures of inflation accomplish this task? The two most widely used measure of inflation are the Consumer Price Index (CPI), and the Implicit Price Deflator for Personal Consumption Expenditures (PCE). The CPI is widely recognized, and is reported both core, and ex food and energy prices. The PCE is used in the computation of Gross Domestic Product, and is also reported ex food and energy. In September the PCE increased 1.31 percent year over year, and the CPI increased .2 percent. My guess is that most, if not all of you reading this feel as if .2 percent hardly reflects the change in costs from September of last year.
If you were to think about real estate prices over the last year being up in excess of 10 percent, and that a mortgage typically represents about 20 percent of income, then housing alone creates inflation of 2 percent (20 percent of 10 percent), yet housing prices are not used in computing the CPI. Rather, the Bureau of Labor Statistics (BLS) uses owner’s equivalent rent of primary residence (OER). Shelter inflation is just the change in equivalent rental prices year over year. The reason the BLS does not use actual housing units to compute inflation is that houses are considered capital (investment). I’ll let you decide if a house’s primary function is as shelter or as an investment.
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This is one of the three largest errors that are made in the current methodology. The second major error is in the BLS’s use of a “hedonic quality adjustment.” This adjustment is designed to capture the increased functionality of technology devices year over year. The easiest example is the iPhone. Each year the price point for the new phone stays the same, yet the computational power is higher. Unless you spend more for the phone the next year, your purchase is actually deflationary. The simple person in me wonders how buying a new phone every two years is deflationary. Thirdly, the BLS does not account for new goods entering the basket. For instance, the cost of the first PC added to basket was not included, just the difference in the cost over the next year. When a cellphone replaced your old home phone, it was deflationary even though it cost you $400 more than your old phone.
Simply said, the CPI does not account for all the goods we now take for granted that were not in existence 30 years ago. Why is this important? We as consumers base our consumption and savings based upon what we see as real-life increases in the cost of living. It is no wonder our savings rate continues to rise. It is past time for the BLS to present an inflation figure to the public that truly represents what they see in their daily lives.
Kevin A. Jones, of Boise, has 28 years of experience in the investment industry and has been a guest lecturer at Boise State University ad Gonzaga University.