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Does CPI Underestimate Inflation to the Detriment of Savers?

Every month, economists and others look at the CPI to determine the rate of inflation in the economy. This measure is one of the factors considered when monetary policy is set. Indeed, inflation – as indicated by the CPI – is one of the items that the Federal Reserve uses when deciding what to do about its Fed Funds Rate. The Fed Funds Rate is used by banks to determine interest rates, including the yield that you get on your savings account. This chain of events that connects CPI to your savings yield is one of the reasons that it is important to understand why it could be a problem if CPI allows the government to underestimate inflation.

What is CPI?

First of all, it helps to understand what CPI is. CPI stands for Consumer Price Index. This inflationary indicator is also sometimes referred to as the cost-of-living index. CPI measures the month-to-month changes in the cost of a basket of products and services. Some of the items that are included in the CPI are food, housing, transportation, clothing, medical services, and education.

It’s not so simple, of course. Various stores, shops, offices and more are called each month, so that economic assistants at the Bureau of Labor Statistics can collect the current price of 80,000 products and services. All of that is averaged together, and if it appears that prices are rising, the government says that we are seeing inflation. However, if prices are falling, we are seeing deflation in the official view.

Because CPI is a measure of averages, though, your personal situation may not be reflected by the government’s view. Indeed, there might be wide disparities in real prices, depending on where you live. Another issue is that the government uses CPI to establish an inflationary trend. This means that the inflation you are experiencing in real life may not be reflected adequately by CPI.

Core Inflation

Things get murkier when you look at core inflation. When figuring this, food and gas prices are taken out of the equation. And this is where things get really frustrating for savers who would like to see higher yields on their deposits to help offset some of the higher prices they are paying. The items that are most likely to fluctuate in price – and show higher increases – are removed from the discussion of core inflation. If you buy food or gas, you know that these items have a big impact on your monthly budget. But when considering monetary policy, the focus on core inflation and inflationary trends can mean that what “real” people are feeling every day could very well be underestimated by the CPI.

CPI Adjustments

The way CPI is measured changed in 1996 after a 1995 report by the Boskin Commission that insisted that the CPI was overestimating inflation. As a result, two major changes were made in the equation used to determine whether price increases were actually happening:

1. Substitution: If the price of hamburgers was looked at as part of the CPI, but people began buying hot dogs as the price of hamburgers rose, then the item looked at would be hot dogs. Then, as prices on hamburgers fell a bit in response, there would be a switch back when people bought them again. Because of the substitution of something less expensive for something more expensive, it would appear that prices weren’t rising – even though they were.

2. Quality: Another issue is that the CPI is adjusted for quality changes. Supposedly, if you are paying a higher price for something that has improved in quality, you aren’t experiencing inflation. Even though you are, in practice, paying a higher price, the government CPI measure says it isn’t inflation, even though your purchasing power has been eroded.

You can see that, as a result of some of these adjustments to CPI, the government might actually be underestimating the rate of inflation – even if it only by a little bit. However, this still has an effect on how much savers are getting.

How CPI Affects You

Inflation obviously erodes your purchasing power. But that will happen whether or not the government recognizes it. The way the government measures inflation has an impact as well. In some cases, the CPI has a direct impact on your every day finances. Here are some things that are directly influenced by CPI:

  • Annual adjustments on inflation-indexed annuities.
  • Social Security payment adjustments (cost of living changes to benefits).
  • TIPS and I-bonds are indexed to the CPI, so your payout on these investments could be affected.
  • Movements in CPI are tied to the size of income tax brackets and personal exemptions, as is the standard deduction.

There is also an indirect effect: When the CPI is lower it is assumed that inflation is low, and that is considered a sign of a healthy economy. Wall Street also likes to see a “reasonable” inflation rate. When inflation is low, there is no need for higher interest rates, which reign in economic growth that appears to be getting out of hand. This helps businesses, but the lower interest rates mean that your savings yields are going to be rather low.

If the government’s measure of CPI is affecting the way it views inflation – and the way interest rates are set – and if that view is that there is an underestimation in the impact of inflation, it could very well be at the detriment of savers. Savers are penalized for their responsible behaviors by seeing lower returns on their deposits. Indeed, the low rates of return on many “safe” places for your money are influenced by the CPI.

On the flip side, though, people who are carrying debt are in a position to benefit. With lower rates, more of their payments go toward the principal, rather than to interest. If you have debt at this point in time, when the CPI is low, it’s a good time to focus on paying it down so that you get out of debt faster. That way, when the CPI indicates that inflation is an issue, and interest rates rise, you’ll be in a position to take advantage.

  |     |   Comment #1
Ur kiddin right, smirks!

Of course that's the whole game they're playin at the CBO, along with Uncle Ben keeping the rates at 0 for an "extended" time,  keeping the banks from paying any decent rates,  they can do the NO COLA thing right along with the 1% 3 year CD's.

This has the same effect on retiree's like someone still working and gets cut to part time, it just makes people spend even less than the feds want people to spend..

  |     |   Comment #2
found this post on another site I did  on this same issue a few days ago.


Its the way they figure to "cut" without actually cutting, by making your costs go up as they keep your "entitlements" down. They don't want you to save any money, they want you to spend it all, and be the slave they want you to be. Of course you'll see 0 in the CPI figures as we get closer to the date of calculation. And Uncle Ben will keep rates at 0 to make you spend what savings you might have since that won't be any income generating vehicle either.

So with prices going UP on everything you need, pay bills for, and tax's, while your income as a retiree stays down with No COLA, and no interest on any savings to supplement, there's no other outcome but to go broke one way or another.

Its like when your house is paid off, but the tax keep coming up to the point your retirement can't keep up with them and you loose the house anyway.

  |     |   Comment #3
What CPI, it is a joke and insult on the American people to even read about it.
The Government is so disconnected of the reality, that nothing less than a revolution can make them come down from their imaginary world of creative financing and budgeting.

Treasury will print the money and loan it to the FEDs, then the FEDs will loan it back to the treasury as IOUs, in a perpetual circle of deceit and debt creation.

We are beyond repair, since the yearly interest on the debt is over $600 Billions a year, not counting the new debt created behind the closed doors and hushed under the table.

FEDs are doing their woo do ritual every time they speak in public by outright misleading us and telling us to stay put and wait for future better days, which will never come.
  |     |   Comment #4
someone should put together a clip reel of the last 10 years of all the crap the Fed has talked about "jump starting" the economy.  They always have an excuse of why they have to "cut" rates and keep them there for an extended period of time.

In spite of  their crap not working, they continue to restate the same policy, over and over again.  Nobody with a brain wants their near Zero percent loans.  Well, the banks do, but that's because they are making a ton of money off the carry-trade. 
  |     |   Comment #5
"If you have debt at this point in time, when the CPI is low, it’s a good time to focus on paying it down so that you get out of debt faster. That way, when the CPI indicates that inflation is an issue, and interest rates rise, you’ll be in a position to take advantage."

This could not be more INCORRECT!  When the CPI is "low" people should take out the maximum of fixed rate long term debt on things like houses, farms, etc.  A "low" CPI means interest rates you pay are also low.  As inflation rises, you will be locked into a very low rate, and the assets you have bought with cheap money will appreciate (or, in the case of houses, stop going down in nominal terms).  Thus, your creditors (who appear to be banks, but ultimately, the honest folk who bought bonds and CDs) will pay to make you richer in real terms, as they grow poorer.

That is especially the case now, because the true CPI, as calculated under the formula used in 1982, before the advent of hedonic and "quality" adjustments and other nefarious frauds committed by the current crop of government statisticians, is running at 8.5%.  Mortgages for 30 years are running at 4.5%, so, if not for the continuation of the slide in home prices, a transfer of assets from CD buyers to buyers of real goods is already happening at about 4% per year.  Problem right now is that home prices will probably decline another 20% over the next two years, for a net loss, if you use the borrowed money to buy a home, of about 6% per year, even with the theft of depositor money.
  |     |   Comment #6
In the previous post, I should have said the transfer of assets from long term CD buyers who are getting, at best, 3% on their money, is running at about 5.5% per year.  The rest of the money is going to the banks, who are borrowing from CD buyers at 3% (at best) and lending at about 1.5% more.  That is why buying long term CDs, right now, is about the most foolish thing that anyone can do, absent an "early out" option, as with the Ally Bank CDs.
  |     |   Comment #7
I should also say to those who will say I am wrong about the current 8.5% inflation rate, you can find the real data, recalculated by economist John Williams, at www.shadowstats.com  He takes the raw data, gathered by the government, and recalculates the inflation rate by the more honest formulas used by the government in 1982, before all the lying started, and the international derivatives mafia (Goldman Sachs, JP Morgan, Barclays, Deutsche Bank, HSBC etc.) took control over the U.S. government.
  |     |   Comment #8
"someone should put together a clip reel of the last 10 years of all the crap the Fed has talked about "jump starting" the economy.  They always have an excuse of why they have to "cut" rates and keep them there for an extended period of time."


Well, you know what they say about the definition of "insanity" is.....I'm just sayin'......
  |     |   Comment #12
Of course the CPI is crooked. How do you think they would keep the stock market going up?

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