The CPI Is a Conspiracy! (Or Maybe You Just Don't Understand It)

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The Consumer Price Index, the inflation gauge produced by the Bureau of Labor Statistics, says inflation was 2.9% in the year ended January. Yet, the average price of a gallon of gasoline went up more than 10% during that period. The price of milk increased double-digits, too. Heating oil prices have skyrocketed.

How do you reconcile these figures? If you're like many, you conclude that the CPI is flawed or, worse, a government conspiracy.

There may be some truth to that. The CPI isn't perfect, and the incentive for the government to downplay inflation is obvious. But that's no excuse to make blind criticisms, particularly when you're an established member of the media.

Enter CNBC host Rick Santelli.

Last week, Santelli pointed out that American Institute of Economic Research issues its own measure of "everyday" inflation, which shows prices rising 8% annually. He explains:

Their Everyday Price Index doesn't look at things that you buy on a grand scale -- maybe every couple of years like a house -- they look at things that you actually consume on a daily, weekly, monthly basis. And do you know what their inflation rate is? Eight percent.

OK, so let me get this straight. They are saying 8%, and most of our leaders, especially in the Fed, want us to believe that they have a 2% [core inflation] target, and we're under it. Now if you believe that ...

Hold up there, Rick. A few points.

It's true that many people only buy a home every couple of years. But most people have home payments every month. That's a real expense, just like milk or gasoline. There's no reasonable excuse to exclude housing from an inflation gauge. Indeed, 41% of the CPI is made up of housing costs, and since the housing market has been ravaged, overall inflation has battled serious headwinds.

Why does housing make up more than 40% of the CPI? Some say it's a trick to suppress the real rate of inflation. Others (rightly) say it's because surveys show about 40% of an average household's income goes to housing costs.

That's really the heart of this issue: weightings. The reason the price of things like milk can rise faster than the CPI is because the CPI is comprised of more than milk. The index's latest numbers show dairy products make up about 1% of the overall index. It also shows -- and this is really important -- that dairy prices surged 9% last year. But since dairy holds only a small weighting in the index, prices can rise a lot without making a big difference on the overall total.

Same with meat, poultry, and eggs. The CPI shows prices for these items jumped 7.2% in the last year. But they hold a 2% weighting in the index, so the overall impact isn't that much. The price of fats and oils rose nearly 13% last year, but make up well under 1% of the index. Average gasoline prices rose 10% in the last year, which is exactly what the CPI shows. But gas only makes up 5.5% of the index. And again, that's because surveys show most people spend about 5% of their income on gas.

The American Institute of Economic Research's Everyday Price Index Santelli cites changes the weightings around. Here's how the organization explains it:

Because the EPI takes into account only a subset of all consumer expenditures, fuel and energy costs account for a larger portion of the EPI than they do for the CPI. Rising and volatile fuel and energy prices made the CPI more volatile in recent years as well, but they had a much stronger effect on the EPI. ...

Food and beverage expenditures, for example, constitute a major part of everyday spending -- between 38 and 47 percent over the years. Even small changes in the price of food affect the EPI significantly. ...

In essence, we each have our own Everyday Price Index. People who spend more of their money on products with rapid price increases have seen their cost of living rise even more dramatically than the EPI suggests. This includes people who spend more on fuel and transportation, prescription drugs, tobacco, cable TV (part of the recreation category), and child care.

On the other hand, people who are very healthy or who do not smoke are not at all affected by rapid price increases in prescription drugs and tobacco. People who spend more on products that are experiencing falling prices -- such as personal care products and services, household supplies, food and beverages, and phone and Internet service -- saw their everyday cost of living rise more slowly than the EPI suggests.

The most important line there: "[T]he EPI takes into account only a subset of all consumer expenditures."

Yes, the prices of things like fuel and food are rising very fast right now. Both CPI and EPI admit this. The difference is how those items are weighted. CPI weights them based on how most people spend their money. EPI gives them more weight while excluding other items entirely in order to highlight specific changes. If you spend close to half your income on food and don't have any housing payments, the EPI index might be a good benchmark for you. If you're an average American, CPI is probably more indicative of your situation.

Or maybe it's somewhere in between. The smartest point EPI makes is that "we each have our own Everyday Price Index." I hardly drive at all, so gas prices don't mean much to me. But I probably eat twice as much fruit as most people, so that's really important to me. I spend $10 a month on milk, so even when prices rise 20%, I hardly notice. Rent is my largest expense, so even small percentage changes there add up fast. For other people, these weightings are far different. It's all about your individual circumstances.

Same for the CPI. It's an average index that doesn't apply to any specific person, or to specific items like milk or gas. That might make it less useful to you, but it doesn't make it a conspiracy.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

At the time this article was published Fool contributorMorgan Houseldoesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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