CPI-U Components

How Taxes and the Consumer Price Index (CPI) Component Weights Hide Inflation

The U.S. Department of Labor Bureau of Labor Statistics (BLS) is THE source for economic data, but interpretation is another matter. One of the most important statistics in our economy is the Consumer Price Index (CPI), which is used in inflation calculations that affect everything from social security payments and union labor agreements to the interest rates on tax-free inflation protected bonds and inflation protected treasuries (TIPS). The question is, does the CPI really measure inflation, as experienced by the typical American? I believe the BLS has done their best to ensure that it does, and they're a lot smarter than I am, but I still think they got it wrong. The CPI number most frequently quoted is the CPI-U number, calculated for urban consumers only. The BLS also publishes a C-CPI-U index, Chained CPI-U, which is an attempt to better express real changes in the cost of living.

But I'm convinced that the current CPI component weighting hides inflation. The most important factor as of late is simply taxes. When your local real estate taxes rise every year, when your state adds a new tax for eating out or for beer, raises fees for your driver's license or mandates a new program, like the Massachusetts and their helath care insanity, the result is immediate. A sole proprietor with a $40,000 income (two thirds of the state's mean) who is fined over $1000 for not purchasing a provate HMO policy has seen a 4% jump in pre-tax inflation, and the related loss of savings and living standard. The components weighting is determined by survey and I have pretty good faith in the ability of the BLS to construct and carry out the large scale surveys, so maybe the problem is with the average American consumer's spending habits. Working from the last component weighting breakdown (relative importance) I could find, I constructed the following table:

CPI Component Weight (U.S.) Northeast Midwest South West

Food and Beverages 14.992% 15.503% 15.102% 14.979% 14.477%

Housing (includes utilities) 42.691% 44.851% 41.130% 41.742% 43.271%

Apparel 3.7260% 3.982% 3.552% 3.660% 3.732%

Transportation 17.249% 15.558% 17.188% 18.155% 17.660%

Medical Care 6.281% 5.338% 7.079% 6.766% 5.843%

Recreation 5.552% 5.191% 5.917% 5.452% 5.679%

Education and Communication 6.034% 6.185% 6.312% 5.791% 5.968%

Other Goods and Services 3.476% 3.391% 3.719% 3.456% 3.371%

The first thing that becomes clear is that the CPI is built to measure the out-of-pocket expenses of Americans. In other words, the fact that a housing in your area has risen 20% per year for the last five years doesn't mean to the CPI that housing has inflated by 100%. The CPI only cares about how much the average out-of-pocket housing expense has gone up. This means is everybody changed their mortgages to interest only mortgages to lower their monthly payments, that part (owner's equivalent rent of primary residence) of the CPI housing component would fall, even as home prices doubled. Similarly, medical care which is averaged at just under 6% of the CPI across the country is measuring the out-of-pocket expense for medical care, not the actual cost of that care which is rapidly approaching 20% of the GDP! Education cost are averaged across a population of who only a small percentage are paying for education in any given year, For a $25,000 college bill for one student to be just 3% of your budget (half of the Education and Communication component is for phone bills and cable TV), the family would have to be earning over $833,000 a year.

So, for years I've been convinced that the CPI underreports inflation because we are imported deflation from China and other low labor cost exporters. It turns out that cheap imports have very little to do with how the CPI hides inflation, those imports deflationary effects mainly being felt in apparel, some furnishings, and some other quasi-durable goods, like tools and electronics. The CPI might do a decent job tracking inflation with food and energy because they are largely paid for as they are consumed, but the CPI hides the massive inflation in Healthcare, Housing and Education. Skeptical financial commentators like to get worked up of the core CPI number when it's reported ex-food and ex-energy, as if taking these components out was somehow lowering the inflation number. It turns out that food and energy are two of the few components that track inflation at all.

The average cost of housing in the U.S.doubled between 1994 and 2006, but the CPI was only up 36%. The real estate tax rises with both higher house assesments and rate increases, well above the stated inflation rate. The average cost of a family healthcare plan rose from $7,000 in 2001 to $11,500 in 2006, an increase of 64% in five years. The CPI was up just 14% in those five years. But it turns out the BLS put a tremendous amount of thought into how they account for housing costs in the CPI. However, they do so with the stated purpose of creating a Cost Of Living Index (COLI). The cost of living is inferred to be an accurate relative of inflation because it describes what happens to a consumers cash flow in any given year, but inflationary pressures are easily hidden by creative financing low interest rates. If the Fed really look at the CPI as part of their interest rate setting decision process, but the CPI is partially dependent on the very interest rate they are setting, we get a feedback loop that probably acts to keep both the CPI and the interest rate moving in the same direction, regardless of asset inflation or deflation. Since inflation and deflation are intimately tied to monetary policy, it starts to sound like anything but a middle of the road course will always lead to bubbles and collapses.

If I understood what they were getting at with the rental equivalency, they take housing appreciation into the calculation. If you live in a hot market where housing goes up every year, in the equity balance, you might even come out ahead, thus lowering the CPI. But what happens when housing peaks and starts down? You don't get any appreciation, you get loss, so your rental equivalency cost shoots up. This feeds back into the CPI rising, which forces the Fed to raise interest rates, which further depresses the housing market, which causes your rental equivalency cost to rise, to, oops! Sounds like a feedback loop to me.