Thursday, July 10, 2008

Real Inflation: Trimmed Mean PCE

It looks like the real inflation rate in May 2008 was 5%. See

The United States still uses a grossly fallacious measure of inflation called, "core inflation," which excludes food and energy prices. This "core inflation" is reflected in a widely-used metric called the CPI, or Consumer Price Index. Using CPI numbers that exclude food and energy, if a tomato goes from 80 cents to 5 dollars each, but a Dell laptop gets cheaper by 100 bucks, the CPI would indicate that overall inflation was going down--which would be inaccurate. Thus, as a statistic, most "core" CPI numbers bring to mind the comment about "lies, damn lies, and statistics."

The Dallas Fed Reserve has bucked this misinformation trend by publishing a more accurate inflation statistic called "Trimmed Mean PCE," which includes energy and food prices. The Trimmed Mean PCE (personal consumption expenditures price index) more accurately reflects the real rate of inflation is because a) it usually includes food and energy prices; and b) it trims, or cuts, unusual numbers that are indicative of generalized noise rather than a long-term inflation signal. The United States' continued use of certain CPI numbers over a more inclusive indicator of inflation means that it is misleading the public, which still has not fully grasped how much money America has printed recently for extraneous expenditures.

For example, if annual inflation is at 4%, and your assets increased by 3%, you lost purchasing power. Money, after all, only has value because it is a means to buy things. If your ability to buy things decreases in the real world, even though the quantity of your money increases, you have fallen behind. America is currently experiencing about 5% inflation while the stock market has caused many portfolios to decrease by 10%, a double whammy. 5 dollars a gallon gas is just one obvious indicator of how massive federal expenditures have harmed the American Dream and Americans' ability to plan ahead financially. Still, if you look at most government figures for CPI, the government's numbers appear understated. The Fed Reserve is telling us that inflation is running at 4.2%, including food and energy, and 2.3% excluding food and energy. See CPI-U for 12 months ending May 2008 (link goes to PDF file):

But the Dallas Fed Reserve believes that inflation is running at 5%. Even the Fed Reserve member banks cannot get their story straight. Using several conflicting CPI numbers allows the federal government to keep printing more money, destroying its real value in the process, and then telling the public everything is okay and the government is properly evaluating inflation. Using a more focused, more accurate indicator of inflation would force the government to be more prudent in its expenditures. The public should be able to log onto the BLS website and get one or two numbers showing real inflation, instead of fifty different numbers. Other figures may still be listed on the government's website, but currently, there is no quick or obvious link to any PCE figure showing real inflation for the month of May 2008. Without such numbers, savers and workers cannot plan ahead to see how much they have to earn to maintain their standard of living.

Without accurate and easily accessible inflation information, a reckless government will print money to satiate the public in bad times, which allows the government to hide failed or short-sighted policies. The Medicare scheme is one such example of a failed government policy that is not being fixed partly because the government can mask the true cost of printing money in a barrage of irrelevant CPI statistics. As a result of public ignorance, the government can delay a real solution to Medicare's underfunded trillion dollar liabilities because it has the political go-ahead to print money to pay benefits if necessary. But, as one of my favorite quotes goes, "a few billion here and a few billion there, and pretty soon, you're taking about real money." That "real money" is the real value of money that savers have toiled to earn, and without more accurate inflation numbers, the United States makes it harder for its citizens to plan ahead and to justify delayed self-gratification.

There is one other interesting side note--the U.S. issues TIPs, or Treasury Inflation Protected Securities. These bonds are linked to inflation as measured by the "core" CPI numbers. These are very popular bonds, and the government may continue to issue billions of dollars' worth of them. As a result, the government has less incentive to shore up its CPI numbers, because doing so means it has to pay more money to the buyers of these bonds.

At the end of the day, a melange of irrelevant CPI figures favors spenders over savers because the more inflation statistics the government publishes that are irrelevant or not fully accurate, the easier it is to shield the public from the true consequences of government spending. The Federal Reserve should heavily advertise only a few inclusive inflation numbers and consider eliminating CPI, especially when PCE offers a more accurate inflation rate.

Update on July 11, 2008: according to my T Rowe Price newsletter, "inflation, as measured by the Consumer Price Index, was up to 4% for the one-year period ending March 31, 2008...U.S. inflation has historically averaged 3.1% for the 80-year period from 1926 through 2006."

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