Inflation is a tricky game
On February 19th, the Bureau of Labor Statistics (BLS) recently reported that inflation, as measured by CPI, remains low in the United States at a non-seasonally adjusted 12 month rate of 2.6%. On February 12th, 2010 Olivier Blanchard, the IMF’s chief economist, called for central banks to raise their inflation targets, perhaps to 4% from the current standard around 2%. I find it interesting that this recommendation comes as nations across the globe are facing the momentous challenge of controlling the potential time bomb of their “quantitative easing,” a polite term for printing money, while Germany and the EU debate how to bail out Greece. Remember that debtors love inflation!
The most widely used measure of inflation in the United States is the Consumer Price Index (CPI), published by the BLS. According to the BLS,
(1) The index affects the income of almost 80 million people as a result of statutory action
- 47.8 million Social Security beneficiaries
- About 4.1 million military and Federal Civil Service retirees and survivors
- About 22.4 million food stamp recipients.
(2) Since 1985, the CPI has been used to adjust the Federal income tax structure to prevent inflation-induced increases in taxes.
The BLS calculates CPI using a weighted basket of goods and services, with occasional substitutions to account for changing preferences, using hedonic regression. There is much debate over the accuracy of the CPI, but it is clear, given the stakeholders mentioned above that there is a potential conflict of interest for the federal government in reporting accurate data.
(1) The higher the CPI, the more the federal government’s expenses increase, such as Social Security benefits.
(2) By keeping CPI below the actual rate of inflation, federal tax receipts rise as tax payers are pushed into higher tax brackets through inflation induced wage increases rather than a true increase in purchasing power. This is illustrated in the example below.
| 25% Bracket | Reported CPI | Wages | Actual Inflation | |
| Year 1 | 30,000 | 3% | 28,000 | 8% |
| Year 2 | 30,900 | 3% | 30,240 | 8% |
| Year 3 | 31,827 | 3% | 32,659 | 8% |
| Year 4 | 32,782 | 3% | 35,272 | 8% |
| Year 5 | 33,765 | 3% | 38,094 | 8% |
Here we have an individual making $28,000 in Year 1. His/her wage increases along with the true rate of inflation. Tax brackets are adjusted according to CPI to prevent an individual or family from being taxed at a higher rate due to inflation rather than as increase real wage rates. Here we can see that if CPI is reported to be 3%, the bottom of the 25% tax bracket increases by only 3% a year while wages increase at 8% a year. By Year 3 the individual is squarely in the 25% tax bracket although real wage rates/purchasing power has not increased. So now they are paying higher taxes, although inflation-adjusted income has remained flat. This means the federal government can increase tax receipts by creating inflation above the reported CPI. I’m not aware of any government in history that would be able to resist that temptation!
There’s both opportunity and motive for bias and manipulation. Be skeptical. The chart below shows the percentage change in CPI as reported by the BLS starting in 1959 vs. the seasonally adjusted M2 as reported by the Federal Reserve. M2 is currency, traveler’s checks, demand deposits, and other check-able deposits, Money Market Mutual Funds, savings, and small time deposits. M3 is considered the best estimate of the money supply and includes time deposits over $100,000, institutional money market funds, short-term repurchase and other larger liquid assets in addition to M2, however the Federal Reserve stopped reporting on M3 in March 2006, thus I have used M2 as an approximation.
CPI has not kept up with the increase in the money supply, thus I would argue that CPI has been understating inflation since around March of 1982. You might recall that the 10 year Treasury Bond hit a high of 15.32% in September of 1981 under Volcker as he sought to combat a brutal inflationary environment with a sharp spike in interest rates. At this time as well, unemployment had reached a 26 year high of over 10%.
The BLS states that, “As the most widely used measure of inflation, the CPI is an indicator of the effectiveness of government policy.” Again, the government is incentivized to show lower CPI. Be skeptical when there are conflicts of interest.
