One of the things I try to accomplish with this blog is to illustrate how the economy works to the non economist who wants to understand better how the economy works and effects their pocket book. Today. One of my most popular posts was one of my earlier ones explaining how real vs. nominal rates affect your wealth. Almost a year later its still one of the most viewed posts.
Today we will examine CPI, how its been calculated over the years and how it impacts you, especially with regard to social security. Its especially timely given that in the fiscal cliff negotiations, one of the proposals is to yet again change how CPI is calculated in order to save the government money by providing less social security while taxing others at higher rates.
The Washington Post commented recently:
Making such a change also means paying out less in Social Security benefits over time — something liberal Democrats can’t stomach. Imagine, for example, a person born in 1935 who retired to full benefits at age 65 in 2000. People in that position had an average initial monthly benefit of $1,435, or $17,220 a year, according to the Social Security Administration. Under the cost-of-living-adjustment formula and 2012 inflation, that benefit would be up to $1,986 a month in 2013, or $23,832 a year. But if payouts were adjusted using chained CPI, the sum would be around $1,880 a month, or $22,560 a year — a cut of more than 5 percent and more as the years go by.
As for taxes, the nonpartisan Tax Policy Center has calculated that most Americans would pay a little more than $100 more per year. Families making between $30,000 and $40,000 a year would see the biggest increases — almost six times that faced by millionaires — but that’s because upper-income Americans are already in the top bracket and not being pushed into higher marginal rates because of changing bracket thresholds.That's because even as your income may be going up in absolute numbers, your real pay may only buy you what you were able to buy before, but with higher taxes. You begin to slip into higher tax brackets even though in real inflation adjusted terms you're not making any more. This has been true of people who now pay AMT (alternative minimum tax) that was originally designed to hit the rich but has been, in recent years, hitting more and more upper middle income people.
Below is an excellent explanation with quotes from John Williams of Shadow Stats, who reconstruct inflation rates based on old calculations to help its subscribers understand what the real inflation rate in apples to apples comparisons.
From Zerohedge:
The subject of inflation has remained an
emotionally charged topic of debate over the last several years. As
rising prices for individuals, and businesses, has negatively impacted
their prosperity; reported inflation has remained at very low levels. With
the Fed pumping trillions of dollars into financial system the fear of
much higher inflation, as the dollar is debased, has caused gold prices
to soar in recent years. As we will discuss momentarily, the
issues surrounding government spending, and the massive deficit, has
brought the topic of inflation to the forefront of the political debate.
However, a bit of history is needed for
context. The government produces a measure of inflation called the
consumer price index (CPI) which is generally broken down into two
reports: Headline and Core. The only difference between the two
measures is that the core reading strips out the volatile food and
energy components. It is this core reading that economists, and the
Fed, focus on much to the aggravation of average consumers who quickly
point to the fact the food and energy are big part of their daily lives.
The sole purpose in measuring
inflation is to help businesses, individuals and government adjust their
financial planning for the impact of inflation. Inflation erodes future purchasing power, and decreases economic prosperity, if not accurately accounted for. The accuracy of measuring inflation, and accounting for it properly, is essential to long term economic prosperity.
The original calculation of CPI, which
measured the change in the cost of an identical fixed basket of goods
priced at prevailing market costs each period, worked reasonably well
for the intended purpose into the early-1980’s. However, as the
pressure of increasing deficits weighed on political parties, the need
to find solutions to reducing spending, without actually cutting
spending, led to several substantial changes in the calculation of
inflation.
Shortly after Clinton entered
the White House the Bureau of Labor Statistics (BLS) altered the
calculation of inflation by changing the weighting of goods in the CPI
fixed basket. Then, over subsequent years, the method of
weighting the underlying components was changed from a straight
arithmetic weighting method to geometric. The primary result of the
switch to a geometric weighting was a lower weighting to CPI components
that were rising in price, and a higher weighting to those items
dropping in price which led to lower reported inflation.
According to John Williams:
“…the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third.”
But the manipulation of the data did not stop there.
Aside from the weighting changes the BLS instituted a system of
“hedonic” adjustments. Hedonics adjusts the prices of goods for the
increased pleasure the consumer derives from them.
“That new washing machine you bought did not cost you 20% more than it would have cost you last year, because you got an offsetting 20% increase in the pleasure you derive from pushing its new electronic control buttons instead of turning that old noisy dial, according to the BLS.When gasoline rises 10 cents per gallon because of a federally mandated gasoline additive, the increased gasoline cost does not contribute to inflation. Instead, the 10 cents is eliminated from the CPI because of the offsetting hedonic thrills the consumer gets from breathing cleaner air. The same principle applies to federally mandated safety features in automobiles. I have not attempted to quantify the effects of questionable quality adjustments to the CPI, but they are substantial.”
Lastly, there is "intervention analysis" in the seasonal adjustment process. Intervention analysis is critical to the highly volatile areas of food and energy.
When a commodity, like gasoline, goes through periods of violent price
swings the BLS steps in and uses “intervention analysis” to smooth out
the volatility. As a result, sharply rising gasoline prices are never
fully reflected in the reported headline inflation number. However,
declining prices, which are never adjusted, do show an impact to
reducing inflation.
The obvious problem with these manipulations is it changed the measure of inflation from a cost-of-living adjustment to a reduction-of-living adjustment.
The original CPI calculation allowed individuals to understand the rate
of return required on investments and incomes to maintain their current
standard of living. However, by artificially suppressing the rate of
inflation, the future standard of living is reduced to lower levels.
The chart above shows the original calculation of inflation (which was based on a basket of goods),
data sourced from John Williams, versus the current measure of CPI. It
is quite apparent that inflation, as reported by the Consumer Price
Index (CPI), is understated by roughly 7% per year.
The deviation between the two
measures is strictly due to the redefinitions of the series and
adjustments to price measures utilized. These changes to the
CPI have detached the cost-of-living adjustments from the real
cost-of-living experienced by those dependent upon a fixed income stream
for survival.
According to John Williams:
"In particular, changes made in CPI methodology during the Clinton Administration understated inflation significantly, and, through a cumulative effect with earlier changes that began in the late-Carter and early Reagan Administrations have reduced current social security payments by roughly half from where they would have been otherwise. That means Social Security checks today would be about double had the various changes not been made. In like manner, anyone involved in commerce, who relies on receiving payments adjusted for the CPI, has been similarly damaged. On the other side, if you are making payments based on the CPI (i.e., the federal government), you are making out like a bandit."
This is why the average American
has repeatedly lashed out at the current measure of inflation as it
doesn't represent the inflation rate that they are personally
experiencing. Rising food and energy costs are consuming more and more
of a declining level of incomes. For those individuals
dependent on a fixed stream of welfare payments the lower rate of
inflation adjustments, while putting more money in the coffers of the
government, has led to a steadily declining standard of living for the
elderly.
The Chained CPI “Fiscal Cliff” Farce
In the latest attempt to save the economy from the "fiscal cliff" a grand bargain is being crafted that will possibly include a relic from the debt ceiling debate in 2011 called "Chained CPI." As
with the Clinton Administration, once again the need to reduce
government spending has given rise to a proposal to further suppress the
measure of inflation to reduce the cost of living adjustments for
social security recipients. The issue with "Chained CPI,” as
with the current measure of CPI, is that it will further misrepresent
what the average consumer is living with from day to day.
The Washington Post stated:
“Economics and policymakers generally make the assumption that when prices rise, people will turn to a less expensive product. They’ll buy chicken instead of more expensive beef, iceberg lettuce instead of arugula, store-brand, instead of name-brand cereal. The chained CPI attempts to account for how people react to inflated prices.It’s an arcane detail in the ongoing budget debate, but the chained CPI is appealing to budget experts and some Republicans and Democrats, because it only slightly tweaks the inflation formula, while building significant savings over time, perhaps more than $100 billion over a decade.Making such a change also means paying out less in Social Security benefits over time — something liberal Democrats can’t stomach. Imagine, for example, a person born in 1935 who retired to full benefits at age 65 in 2000. People in that position had an average initial monthly benefit of $1,435, or $17,220 a year, according to the Social Security Administration. Under the cost-of-living-adjustment formula and 2012 inflation, that benefit would be up to $1,986 a month in 2013, or $23,832 a year. But if payouts were adjusted using chained CPI, the sum would be around $1,880 a month, or $22,560 a year — a cut of more than 5 percent and more as the years go by.”
When it is known in advance that tweaking the math will create a "permanent" reduction in the measure of inflation then it is no longer an accurate assessment of inflationary pressures in the economy.
If adopted across the government, the change would have far-reaching
effects on the many programs that are adjusted each year based on
year-to-year changes in consumer prices.
The groundswell of aging “boomers”
that will are rapidly approaching the point of become welfare program
recipients will find that the fixed stream of income payments will not
be sufficient to maintain their current standard of living in the
future. This will continue to push an ever aging population into working much longer into their retirement years.
Furthermore, a side effect of
artificially suppressing inflation is that taxes would slowly increase
because annual adjustments to income tax brackets would be smaller.
This would eventually push more people into higher tax brackets
allowing fewer people to be eligible for anti-poverty programs like
Medicaid, food stamps and school lunches. While the annual adjustments
will eventually remove individuals from poverty on a statistical basis –
it doesn’t mean that would be any more capable of supporting
themselves.
Lastly, one reason why there has
been such a disconnect between reported GDP, and the way that average
Americans feel about the economy, is due to the way CPI affects the GDP
calculation. Although the CPI is not used in the actual GDP
calculation, there are relationships with the price deflators used in
converting GDP data and growth to inflation-adjusted numbers. The more
inflation is understated, the higher the inflation-adjusted rate of GDP
growth that gets reported. The problem is that real inflationary
pricing pressures is simultaneously eroding the real prosperity of the
average consumer.
While going to "Chained CPI"
will save the government over $100 billion during the next decade in
payments to individuals - this is not a good thing for those dependent
upon those payments. Furthermore, the assumptions for
budgeting will also be grossly flawed which means that when we get to
the end of this decade it is likely that we will be in worse shape than
was estimated. Hopefully, those in Congress will opt not to further
suppress the inflation calculation for political gain at the expense of
the average American.
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