Why inflation is overstated because of CPI?

The last quarter of 2021 was marked by growing concerns about the rate of inflation as consumers saw everything from groceries, energy, clothing, and leisure activities rapidly increase in price. The U.S. has recorded a 7% inflation rate, its highest in four decades! Investors panicked and began pouring money into inflation protection instruments like TIPS which collected net flows of $61 billion in the first 10 months of 2021, 3 times more than 2020’s net inflows. Should you worry about inflation figures? In this article, we explore what inflation is, how it is calculated and how you can protect your wealth from its deleterious effects.

What are inflation and CPI?

The Consumer Price Index, more often referred to as CPI, is simply a measure of the price of a basket of goods and services that are commonly purchased by a family. It aims to represent the cost of consumption to the average household in an economy. The CPI is made of subindices that represent categories of goods and services such as food, energy, or transportation.

The percentage variation of one CPI compared with the CPI of a base year is called inflation. For example, if in November 2020 the CPI was 100 since the U.S. experienced 6.8% inflation from November 2020 to November 2021, this means the CPI in November 2021 was 106.8.

CPI’s accuracy is limited

Like any average measure, the CPI’s accuracy is limited and doesn’t always paint the full picture. 5 biases are often referred to when we talk about the CPI:

1 - Substitution Bias

When the CPI is constructed, it assumes consumers will continue buying the same quantity of a good or service regardless of their cost. You don’t need a Ph.D. in Economics to understand this is incorrect. When prices rise, consumers will search for a substitute for the goods or services they are trying to purchase. For example, today the kilo of ground beef is $15, if tomorrow the price doubles people are likely to decrease their ground beef consumption and switch to a cheaper substitute such as chicken or pork.

However, the components of the CPI are only reviewed every two years. Therefore, even though the ground beef will still be on the CPI at the same weight, households will consume less ground beef. This translates to a loss of representativeness of the average household consumption. This is called the substitution bias.

2 - New Goods Bias

Newly introduced products are not immediately captured in the CPI. The price of many goods significantly falls in the early months after their launch on the market. Again, this fall is not reflected in the CPI. For example, when the first mobile phones were introduced to the market, they were extremely expensive and only a privileged part of the population could afford them, then they spread, and their price decreased.

3 - Quality of goods bias 

Over time, most goods and services’ quality improves. To keep up with the mobile phone example, let’s say you spend $500 on a mobile phone, you will get a much better phone than you would have had 5 years ago. Since the quality increases, it is normal that prices also increase. Every year Apple releases a new iPhone more expensive than the previous one because of the new features. Hence, the rise in prices is explained by an improvement of the product, not by inflation itself. For some goods, the quality-adjusted price will even fall over time! The CPI attempts to adjust for this bias but it is difficult to fully capture this effect.

4 - Outlet Bias

The prices of the CPI’s goods and services are obtained from traditional shops, supermarkets, or department stores. This style of consumption is not representative of today’s prevailing model. A large number of households shop at large discount stores or online because it is cheaper and more convenient.

The Bureau of Labor Statistics (BLS) has started to collect data from those channels but there is still a large bias towards traditional consumption channels which leads prices to be overvalued.

5 - Housing Bias

The Housing Bias bias is not as known as the others and was introduced by a research paper published in August 2021 that proves the lack of representativeness of the current rent prices. Indeed, the BLS estimates rental costs using a repeated survey of existing tenants. The results are used to measure the renters’ and owners’ shelter costs. However, this survey tends to overrepresent sitting tenants and underrepresent new tenants. This means the measurement of the rental costs is likely based on rental contracts that were signed some time ago and therefore not representative of the current market prices.

This bias results in astonishing differences between home price indexes and the shelter subindex of the CPI. For example, as of November end 2021, the Case Shiller Index was up 28% while the shelter subindex of the CPI was only up 3.8%!

This is an important subject since the shelter subindex represents approximately 30% of the CPI.

Inflation could be overstated but…

Even though the CPI is biased, it still gives an idea of the price evolution of goods and services the average household purchases. The 4 first biases let us suppose that the inflation is overstated but the last indicates the opposite and touches the major subindex: housing.

Overstated or understated, inflation is here, and you should not let your money devaluate because of it!

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