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“Heady Stuff:” The Wall Street, Inflation and the CPI

The Wall Street Journal’s opinion page has never been a place where reality is a binding constraint. Andy Kessler demonstrates this fact in a column that tells us that the Consumer Price Index (CPI) overstates the true rate of inflation by at least 2.0 percentage points annually and possibly as much as 5.0 percentage points.

The immediate basis for this observation is an interview Alan Greenspan gave in which he said:

“Because products are continuously changing, ….. when new products go on the market, they come in at relatively high prices. Henry Ford’s Model T came in at a very high price, and the price went down as technology improved. You didn’t start to pick up the price level until well into that declining phase.”

“So there is a bias in the statistic. You’re getting statistics which are not correct. … If you had a 2% inflation rate as currently measured, it’s the equivalent of zero for actually what consumers are buying.”

As Kessler describes it, “pretty heady stuff from the former Fed head.”

Perhaps, but it’s hardly new. Greenspan made the same observation more than a quarter-century ago. He told Congress back then that the CPI overstates inflation by at least 1.0 percentage point, and possibly as much as 2.0 percentage points. He suggested that Congress could use this alleged fact as a way to reduce the budget deficit, since Social Security payments (post-retirement) were linked to the CPI, as were income tax brackets. If the annual inflation adjustment in these measures was 1.0-2.0 percentage points lower, it would drastically reduce Social Security benefits over time and raise a great deal of tax revenue.

Congress picked up on Greenspan’s testimony and created a commission chaired by Michael Boskin, the head of the Council of Economic Advisers under the first President Bush. The commission concluded that the CPI overstated inflation by 1.1 percentage points annually, based largely on research from the 1960s, which made the same argument that Kessler cited from Greenspan. In other words, the claim that the CPI misses the wonderful benefits of technology is more than half a century old.

In addition to being an old argument, this is also largely an incorrect argument. While Greenspan asserts that when a new product comes onto the market it is priced very high and then the price falls sharply, but “you didn’t start to pick up the price level until well into that declining phase.”

Greenspan may not remember, but because its own research has identified this problem, the Bureau of Labor Statistics (BLS) began to accelerate the rate at which new products are introduced into the index. It reconstructs its basket annually and important new products are likely to enter the index after just a few months.

It’s also worth noting that insofar as this story of rapid price decline in new products leads to an overstatement in the cost of living, it is only for the rich. Take the famous example of the cell phone, which slipped through the cracks and did not enter the index until 1996, when close to 40 percent of households owned one. While this 40 percent benefited from the sharp drop in prices from well over $1000 to $200, the 60 percent who still did not own a cell phone did not benefit from the drop in prices. They were making the decision that even at a price of $200, they had better uses for their money.

Due to changes in methods, there will not be another product like the cell phone that can achieve mass adoption before getting in the CPI, but there may still be extremely expensive new items purchased by the rich, which drop rapidly in price in the few months before they are introduced into the CPI. Insofar as this is the case, we are overstating the rate of inflation experienced by the rich, which would be an argument for a lower indexation figure for top tax brackets, thereby subjecting more of their income to a higher tax rate.

It is also worth noting all the factors that suggest the CPI understates inflation. BLS does make major efforts to measure quality improvements, but it undoubtedly misses some. But it also misses deterioration in quality. Most people would probably say the quality of air travel has deteriorated over the last three decades with smaller seats, more crowded planes, and having long waits in security lines. This deterioration has been largely overlooked in the CPI.

Also while new technologies offer great benefits, they also impose costs. It would be very difficult to get by these days without a cell phone or access to the Internet. Yet the cost of owning a cell phone and the cost of access to the Internet do not figure into the CPI. It only picks up changes in these costs, not the fact that new technologies have imposed large additional costs on households.

Any serious analysis of the CPI as a measure of the cost of living will show biases on both sides. Politically motivated people can just cite one side to push their agenda, but this sort of stuff need not be taken seriously outside of the Wall Street Journal’s opinion section.

This article first appeared on Dean Baker’s blog.

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Dean Baker is the senior economist at the Center for Economic and Policy Research in Washington, DC. 

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