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«Is inflation overstated? Correctly measuring inflation is crucial to understanding what is going on in the economy. It matters even more to anyone whose ...»

April 2016 For professional investors and advisers only

Is inflation overstated?

Correctly measuring inflation is crucial to understanding what is

going on in the economy. It matters even more to anyone whose tax

or pension is linked to an inflation benchmark. There should be no

surprise, therefore, that the accuracy of official inflation measures

is often the subject of heated debate. We have looked at one of the most influential, the US consumer price index (CPI)1, in the light particularly of the impact of new technology. We concluded that it has consistently overstated the rise in prices, something which could have widespread ramifications. Hundreds of millions of dollars of unnecessary social security and pension payments may have been made, while real GDP may have been consistently understated.

And although the effects on markets and monetary policy are less clear cut, wrongly-recorded inflation may have introduced distortions to both.

One of the most far-reaching studies of the CPI was published in 1996 by a commission appointed by the US Senate to look at its use in government benefit programmes, chaired by Michael Boskin, an academic economist. The main conclusion was that CPI inflation

was overstated by 1.1 percentage points a year as a result of several upward biases2:

– The inability to adequately account for consumers switching expenditure between different expenditure categories, known as upper-level substitution bias.

– The inability to account for consumers switching between goods within an expenditure category, termed lower-level substitution bias.

– A quality and new goods bias arising when the CPI’s compiler, the US Bureau of Labor Statistics (BLS), failed to adjust sufficiently for the enhanced quality of goods and services. In addition, it was thought CPI missed the decline in the price of new goods between their being introduced to the market and going in to the index.

– Outlet bias as a result of consumers changing where they make their purchases, with the CPI not picking up the same goods being sold more cheaply at discount stores.

Figure 1 quantifies these four biases. It can be seen that substitution bias alongside quality change and new goods bias were believed to account for the majority of the overstatement of CPI.

1 Here we are referring to CPI-U, which tracks prices typically paid by the urban consumer.

2 Toward A More Accurate Measure Of The Cost Of L

–  –  –

The Boskin Report is just one of a handful of studies that have attempted to quantify the bias found in CPI. The consensus of these analyses is that CPI remains biased upwards in the region of 0.6 to 1.1 percentage points a year (see table). The latest studies put a high weighting on quality change and new goods bias. For this reason we have decided to explore this bias in some depth.

Figure 1: The Boskin Report mainly blamed quality and new goods for distorting inflation...

Percentage points per annum 1.2 0.10 1.0 0.8 0.60 0.6 0.4 0.25 0.2

–  –  –

* Lebow, Roberts & Stockton did not specify point estimates.

** Lebow & Rudd (2001) define weighting bias as CPI weights being inaccurate in a manner that systematically overstates the change in the cost of living.

Source: Lebow and Rudd, 2001.

As it tracks the cost of a representative basket of goods and services over time, the CPI attempts to make adjustments for the changing quality of the underlying components.

One example would be cars, which have become more reliable, safer and more fuel efficient over the years. Even more dramatic have been the improvements to mobile phones such as the iPhone. Failing to account accurately for these rapid changes in quality will inevitably lead to an upward bias to CPI.

Schroders Is inflation overstated?

–  –  –

One of the greatest drivers to the improved quality and efficiency of goods and services is technological change; so much so that many of the major consumer advances of the last several decades are now being combined in a single product. The iPhone is a classic example of how technology has reduced the need for a whole host of items, including cameras, CD players and GPS systems to name just a few.

Most of this extra convenience to the consumer is not picked up by CPI, which continues to measure the individual items separately6. So whilst the price of an iPhone now is surely higher than a typical phone 10 years ago, the improved functionality and convenience should outweigh the measured price increase. However, price indices such as the CPI struggle to directly capture the enhanced quality of products like the iPhone.

There may be an indirect price effect, however. If these products reduce demand for the goods and services they intend to replace, the prices of the latter may fall, dragging down CPI. The same argument can be used for how low cost apps developed in the last 10 years feed into CPI.

Correcting for the quality of digital content and software is particularly challenging. Much of the new digital content is offered to the consumer at little to no direct cost, thus its contribution to CPI is limited despite apparently improving our welfare. Moreover, even if any bias were corrected, it would have a limited effect. The “Information technology, hardware and services” category in the CPI, which includes digital content, has a weight of just 1.2% (based on 2013–2014 weights).





3 Michael Boskin, Better Living Through Economics: Consumer Price Indexes, American Economics Association, 2008.

4 Christian Broda and David Weinstein, Product Creation and Destruction: Evidence and Price Implications, American Economic Review 100, 2010.

5 David Lebow and Jeremy Rudd, Measurement Error in the Consumer Price Index: Where do We Stand?, 2001.

6 Gavyn Davies, “The greatest unknown – the impact of technology on the economy”, Financial Times, 15 June 2015.

Schroders Is inflation overstated?

Hedonic adjustment is one of the methods the BLS uses to control for quality changes in goods and services. This methodology involves a regression which breaks down the price of a product into implicit prices for each important feature and component, for example processor speeds for computers. At the time it was introduced in 1987, it was aimed at adjusting the rent and homeowners’ equivalent rent sub indices of CPI to reflect an ageing housing stock. More recently, hedonic adjustment has increasingly been used in the construction of CPI sub indices where quality is improving, such as electronics and apparel. As a quality adjustment method though, hedonic adjustment is still only used only for a small number of goods7.

If CPI is indeed overstated, it is likely to affect real output and productivity, government finances, private agreements and, in part, the formulation of monetary policy. Let us first consider the impact on real GDP. The national income and product accounts (NIPA) use the component CPI indices as inputs in calculating real GDP. However, the US Bureau of Economic Analysis (BEA), which is responsible for compiling NIPA, uses a different method to the BLS to aggregate real series. Known as a chained Fisher approach, this is expected to eliminate upper level substitution bias. Furthermore, the BEA makes some quality adjustments not made by the BLS.

The result is that the overstatement of CPI is not carried across in full to the consumption component of the national accounts, meaning it is potentially in the region of less than 0.5 percentage points per annum8. Assuming a bias of 0.4 percentage points a year and consumption accounting for two thirds of US GDP, Boskin estimates an understatement of real GDP growth of approximately 0.25 percentage points per annum. Adjusting for a 0.25 percentage point a year under-recording of real GDP per capita since 1980 suggests the actual level rose 91.9% between 1980 and 2014, well above the official figure of 76.6%. This is equivalent to real GDP per capita in 2014 being 8.7% higher than official statistics report.

Miscalculation of inflation could help explain the apparently low level of productivity growth experienced by the US in recent years, implying that it had been stronger than officially recorded. However, we cannot say with certainty that the overstatement of CPI, and thus the understatement of GDP, explains the slowdown in US productivity growth.

This would imply that the bias has increased in the last five years or so, which is not entirely clear, despite advances in technology.

The overstatement of CPI has major implications for government finances though. From a revenue perspective, tax brackets are regularly revised upwards in line with the CPI to keep them constant in real terms. With the overestimation of CPI, it is likely to be the case that tax brackets have been over-indexed, to the benefit of the consumer, with the government losing out on significant tax revenues as a result. Also weighing on government finances are outlays linked to CPI, such as social security payments. It is believed that one third of federal budget outlays are influenced each year by changes in CPI9. Hundreds of millions of dollars of additional government debt have and will continue to be accumulated if estimates of CPI biases do turn out to be accurate and not accounted for.

Meanwhile, many private agreements, such as employment contracts and pension payments, are determined by CPI, at least in part. While workers and pensioners may celebrate, this will be viewed unfavourably by companies, whose expenses will be inflated, and by pension providers, whose liabilities will be overstated. Adjusting for the upward bias in CPI could therefore help bring about a reduction in the underfunded status of many pension plans.

7 Jerry Hausman, Sources of Bias and Solutions to Bias in the CPI, The Journal of Economic Perspectives, vol. 17, no. 1, 2003.

8 Michael Boskin, Causes and Consequences of Bias in the Consumer Price Index as a Measure of the Cost of Living, 58th International Atlantic Economic Society Conference, 2004.

9 Michael Boskin and Dale Jorgenson, Implications of Overstating Inflation for Indexing Government Programs and Understanding Economic Progress, American Economic Review 87, no. 2, 1997.

Schroders Is inflation overstated?

Does an upward bias in consumer price indices cause monetary policy decisions to be fundamentally inconsistent with the underlying economy? Currently the Federal Reserve’s chosen measure of inflation uses the core personal consumption expenditure (PCE) price index. One of the motivating factors in 2000 for the Federal Reserve (Fed) switching to targeting PCE inflation rather than CPI inflation was based on the former suffering less from upward bias due to substitution effects10.

Whilst this is not to say the Fed ignores CPI inflation, it does suggest it is aware of the upward bias. It would therefore be reasonable to assume a degree of upward bias is incorporated into the central bank’s 2% inflation target. So where the Fed’s idea of price stability is inflation of 2%, in reality it likely to be slightly lower once account is taken of measurement bias in consumer price indices. In Figure 3 we graph core PCE against core CPI inflation to illustrate the differences in the inflation measures.

Figure 3: How the Fed adjusts for the inflation problem y/y 16% 12% 8% 4% 0%

–  –  –

Source: Thomson Datastream and Schroders, March 2016.

Between the end of 1960 and the end of 2015, core CPI inflation was on average

0.5 percentage points a year higher than core PCE inflation. Although this difference falls short of many estimates of the upward bias, it suggests monetary policy does target a measure of inflation that is likely to be closer on average to the true rate. However, the Fed still faces the difficulty of determining what the bias-adjusted target should be, made more challenging when the size of the bias is forever changing.

Any such bias may have implications for the inflation premia built into bond yields.

If inflation is materially lower than official figures suggest and is expected to remain so, bonds would look better value, as the inflation premium built into yields would be unnecessarily high. Furthermore, longer dated bonds would benefit disproportionately, given that their higher duration means they should benefit from lower interest rates than previously expected. However, it would not be unreasonable to assume the market already discounts some of the bias in CPI. And, of course, this assumes that the inflation component embedded in bond yields is directly linked to CPI. In reality the relationship may not be that significant.

The biases highlighted by the Boskin Report almost certainly go beyond the US and its markets. In the UK, for instance, academics have generally focused on the bias present in the retail price index (RPI), noting that it has a tendency to report a higher inflation rate than the UK’s own CPI. According to one study11, after factoring in the benefits associated with improving internet connections, CPI inflation would have been just over one percentage point a year lower than reported between 2006 and 2014. Assuming UK CPI suffers from the same biases as US CPI, this would suggest the measurement bias in UK consumer price inflation is not insignificant.

–  –  –

Important information: The views and opinions contained herein are those of Marcus Jennings, Economist, and Keith Wade, Chief Economist and Strategist, both at Schroders, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. Reliance should not be placed on the views and information in the document when taking individual investment and/ or strategic decisions. Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get back the amount originally invested.

The data contained in this document has been obtained from sources we consider to be reliable. No responsibility can be accepted for errors of fact and the data should be independently verified before further publication or use. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Issued in April 2016 by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration number 1893220. Authorised and regulated by the Financial Conduct Authority. For your security, communications may be taped or monitored. w48692





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