Does The Government Underestimate Inflation Through The Consumer Price Index (CPI)?

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Many people, including myself, are worried about inflation. Is it just because of the current housing and stock market conditions, or are our bills really a lot higher than before? The inflation numbers that we usually hear about are based on the Consumer Price Index (CPI). Variations of the CPI are published monthly by the government’s Bureau of Labor Statistics, and they supposedly track the prices consumer pay for a basket of goods and services. For example, a greatly simplified basket may include a month’s rent, 10 pounds of steak, a tank of gas, and a laptop. As the price of this basket goes up, that’s inflation.

Why Does CPI Matter?

  1. Payouts on inflation-protected investments like TIPS and Series I bonds are indexed directly to the CPI.
  2. Social security payments, pensions, and inflation-indexed annuities all rely on CPI data to determine their annual adjustments.
  3. The size of individual income tax brackets, personal exemptions, and the standard deduction are tied to movements in the CPI.
  4. Low inflation numbers (especially when they are much less than GDP growth) make the economy seem healthy.

However, there is some controversy over whether the CPI is an accurate measure of inflation. As you can see above, there are many reasons why the government and large pension groups would like to see a lower inflation number. Lower inflation numbers mean lower payouts, a smaller budget deficit, and a happy stock market.

In 1995, the Boskin Commission study suggested that the CPI overestimated inflation by around 1.1% every year, and in 1996 changes were made to counteract these alleged errors. But critics say these changes were completely unnecessary, and now the CPI underestimates inflation by around 1.1% per year. Here are some of the arguments:

Substitution Adjustments
It was suggested that if steak becomes too expensive and people buy hamburger instead, then the CPI should just start using hamburger prices instead. After all, that is what people are buying right? Not only does this reduce inflation, critics wonder where this is headed. Hamburger gets too expensive, so then we eat hot dogs. Hot dogs turn into… dog food?

In addition, let’s say we go from using steak to hamburger due to price, and then back to steak again once it gets cheaper. Roundtrip, this substitution system would say that there was zero or even negative inflation during this time. But obviously prices actually rose. Just doesn’t sound right.

Quality, or Hedonic, Adjustments
A second major factor is that the CPI tries to adjust for increases in quality as well as increases in price. If a car costs 10% more, but it is 10% higher in quality, then there was no inflation. Okay, I can see this in certain examples. But critics point out that many times the consumer has no choice but to pay the higher price, so why aren’t we taking this into account?!

Example: If the government mandates an additive to your gasoline that costs an extra 20 cents per gallon, there is no affect on the CPI because this 20 cents was an improvement in “quality”. But we still get stuck with higher bills!

I wonder… if we follow all these quality adjustment ideas, isn’t shifting from steak to hamburger losing quality and shouldn’t that be adjusted for as well?

What If We Remove These Adjustments?
Here are two estimates of what the CPI number would look like without these adjustments. From Shadows Stats2 (Clinton era means 1996, when the changes were made):


From Bill Gross and PIMCO3:


Personally, I think the government has a vested interest in getting the inflation numbers at least somewhat correct (considering the scrutiny they are under), but at the same time they want to err on the low side rather than the high side. Some of the methods they use definitely seem to support this goal, and I wouldn’t be shocked if the CPI-based inflation numbers lagged what consumers actually experience by up to 1% per year at times. This may be something to consider when buying anything indexed to the CPI.

Sources and More Information

  1. The great inflation cover-up by Elizabeht Speirs, for Fortune Magazine.
  2. Consumer Price Index by ShadowStats / John Williams – Slightly more aggressive and controversial.
  3. Haute Con Job by Bill Gross – He runs PIMCO and the largest bond mutual fund in the world, so not quite a kook. Also see Con Job Redux.
  4. US CPI Inflation Statistics Manipulation and Deception? by Ronald Cooke.
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  1. I think most people worry more about the CPI than they should. It’s just a number, and a retrospective one at that. It doesn’t affect the prices we pay – it merely reflects the prices (accurately or not), after the fact.

    The ones who should really be concerned are people living on Social Security, investors in inflation-indexed securities, or anyone else whose income (or outflow) is pegged to inflation. For them, it’s important that the government gets inflation right.

    Even beyond the substitution effect, the CPI is only updated once every 10 years. With the pace of technology improving our quality of life, I think the CPI probably does vastly overstate the impact of rising prices.

    On the other hand, the “core” CPI strips out food and gas because commodities prices are highly volatile. A lot of people complain that this means the CPI way understates inflation. This may be true in the current environment, but it’s not always the case.

  2. It seems to me that with energy prices rising 10 times over the past decade, inflation would be transferred through to the whole economy. But maybe “this time it is different” 😉

  3. I have heard that the government still overstates inflation since they don’t know how to adjust properly for huge improvements like health care. This is actually more of a problem because if the CPI is 1% and we overstate inflation too much, we might actually be in deflation, far far worse than a little more inflation than stated. This is why the Fed tries to keep inflation between 1-2%. If they tried for 0%, they would be risking deflation, an economic killer. Hope this clears things up.

  4. While I don’t believe CPI is reflective of inflation, I think a lot of that has to do with what inflation really is. One of the governments primary concerns is to measure the impact of changing money supply as measured by inflation. This determines Fed monetary policy. When there’s hyperinflation when the government prints too much money, this effect on inflation is obvious. It’s much harder to measure when the prices we pay are determined more by supply and demand. Hence the reason core CPI excludes food and energy, commodities that are volatile because of fundamental supply and demand factors. The same could be said of memory chips.

    I think also the point made by Mike H is valid. How do you adjust for quality? It’s become increasingly difficult as consumer goods have become much more varied.

  5. Ted Valentine says

    Does the part about “quality” go both ways? I’m sure it doesn’t. Ever notice how nothing is made to last as long as it used to? I’ll bet your grandma has an old vacuum cleaner or fan or hand mixer that she’s had for 30+ years.

    Now everything from small electronics and toys to now even large appliances and cars are more and more becoming throw away. Yeah, the prices go down (and so does “inflation”) but you have replace everything when they break in a year or two.

  6. Do you really think an organization as large and powerful as the AARP, with a huge group of constituents reliant on the accurate reflection of inflation in COLA adjustments, would allow the government to fudge inflation to the downside?

    I am certain that they have armies of well-paid economists and lobbyist ensuring the they get the most favorable inflation reporting for their group, and if anything, that will be biased to the high side.

    While it’s true that the components that go into calculation of one’s personal “inflation rate” varies greatly from person to person, and can make it seem that the government published numbers have no basis in (your) reality, this conspiracy theory of government-mandated understatement is ridiculous.

  7. I’m with Lily. Your sample basket isn’t reflective what’s included in core CPI. CPI doesn’t include food, fuel, and housing.

    Clearly, there is a disconnect between what is tracked in the core CPI (the one that’s quoted in the press) and what the current pain points are for Americans. The obvious conclusion is that CPI underestimates inflation.

  8. Unfortunately one of the few things still made in America is inflation. In fact, it now ranks as our greatest export.

    A significant by-product of the current global economic system, wherein Americans spend money they do not earn to buy foreign products that they do not make, is that trillions of dollars are now parked in foreign banks just looking for somewhere to go.

    In a healthy trade relationship, a nation pays for its imports with equal exports that result from real productivity that pumps up demand. In contrast, the current U.S. import boom has been created by the artificial demand of inflation, in which increased money supply has put more dollars in the hands of U.S. consumers. Normally, such growth in money supply would result in more substantial increases in domestic consumer prices. However for a number of reasons, the United States has been able to partially dodge this bullet. In short, we have exported our inflation abroad.

    Our foreign creditors basically have two choices as how to dispose of their excess dollars. They can use them to buy U.S. financial assets, such as bonds, stocks or real estate, or they can exchange them for other currencies or commodities, such as gold or oil. If they choose the former, foreign central banks are off the hook, as those dollars find their way back to the U.S. economy without any additional money creation. However, as foreigners are increasingly choosing the latter, foreign central banks have been “forced” to print money like it’s going out of style.

    In years past, foreign investors were happy to hold strong U.S. dollars, which they either saved as a store of value, or used to purchase mighty Wall Street stocks and bonds. However, when the dollar began its epic swan dive, and U.S. investments began to grossly underperform non-U.S. alternatives, private investors dumped their dollars en masse by exchanging them for local currencies. The unwanted dollars then became the property and problem of foreign central banks.

    If central banks did not buy these dollars, foreign citizens would have been forced to sell their surplus dollars on the open market. To prevent this from happening these banks have become the buyers of first and last resort. However, to sop up all of the excess supply, central banks must create more of their own, resulting in rapidly expanding money supplies. As much as Wall Street and government economists pretend otherwise, the expansion of money supply is the essential definition of inflation. The real reason that prices are rising in China is that so many yuan are being printed to buy up all these surplus dollars.

    For much of the past decade foreign central banks invested their swelling U.S. dollar reserves in U.S. debt instruments, such as treasuries and mortgage backed securities. Not incidentally, these purchases helped sustain our housing and credit bubbles. But as a result of increasingly poor returns, sovereign wealth funds have recently been created to buy tangible assets instead, such as large portions of Merrill Lynch and Morgan Stanley. Thus far these investments have performed poorly (note the 50% decline in the value of the China’s stake in Blackstone). However, my guess is that such losses are of little concern, as the Chinese understand that any active use of their dollars, regardless of short-term performance, is seen as a positive because ultimately their unused dollars might be practically worthless!

    It is no accident that those regions experiencing the highest inflation are those with currencies pegged to the dollar. The formerly strong dollar provided a compelling rationale for nations with weaker currencies to maintain currency pegs. The linkage provided badly needed discipline to their central banks and created confidence in their currencies. However, it makes no sense at all for a nation with a strong currency to peg to a weaker one. It is analogous to an honor student cheating on his exam by copying the answers from the worst student in the class.

    Many economic analysts have noted that rising prices in China are now resulting in higher import prices for Americans. Ironically, many have concluded that this is evidence of China exporting inflation to the U.S. rather than China merely returning the inflation to its original source.

    Initially, the strong productivity growth of these export nations worked to lower consumer prices and masked the inflationary impact of rapid money supply growth. However, with prices now exploding throughout Asia and the Middle East, governments can no longer ignore the inflation problem. China has recently imposed price controls to deal with rapid increases in consumer prices. However, as this merely attempts to mask the symptoms of inflation rather than addressing its root cause, this policy will prove as ineffective as it did in the United States in the 1970’s. Once all of these misguided cures fail, Asia and the Gulf nations will swallow the only medicine that will work. They will completely pull the plug on their dollar pegs. When they do it will not just be the dollar, but the entire American economy that goes down the drain.

    The manner in which this massive bundle of funds will be disposed will have a gargantuan impact on the trajectory of the world economy. Unfortunately for America, the decisions are out of our hands, but the ramifications will largely be ours to bear.

  9. Actually the media reports the full CPI-U (including food and energy), not the core CPI. The only time I even hear of core CPI is when people want to complain that it doesn’t include energy and food! See for example

    Anyway, some people *still* think the CPI understates inflation by about 0.5% because it doesn’t take into account the full benefits of new technology. For example, cell phones weren’t integrated into the CPI until 1998, although they made communications cheaper for many people before then. It’s also hard to measure their benefit fully. How should we measure the possible time/money savings that come from the internet?

  10. Everyone has some good points. Personally, I believe the government understates inflation, but not nearly as much as some people would have you believe they do. A big reason for the unstatement is the varying quality of goods. For instance, in the past 10 years, computers have remained roughly the same in cost; however, their quality (power/speed, etc) has greatly improved. Thus the CPI would show a decrease in the cost of a computer, even though most computer are unable to use a computer built 10 years ago.

    On the flip side, the CPI may show an increase in housing costs as these costs rise. However, if you own your home with a fixed-rate mortgage, your payment remains the same for the next 30 years. Therefore, while the CPI may increase over 30 years, your housing cost remains much more constant.

    Likewise, inflation affects everyone differently. Many people complain about the rising cost of fuel. I personally spend just $50/month on gas for my car. So if the price of gas rises 10% in a year, I think I can manage an extra $5 a month. Some people who drive more take a greater hit to their budget., however. I think that’s the real problem with calculating the CPI, is that everyone uses different ratios of goods.

    Finally, I think a big problem with perceived inflation is actually lifestyle inflation. Sure, your bills are higher, but how much more to you have now than you did 10 years ago? Who had an iPod 10 years ago? How many people have iPods now? How had cell phones 10 years ago, versus how many people have the latest and greatest cell phones today (with $60 monthly bills to boot)? If you really consumed exactly the same amount of stuff today as you did 10 years ago, I think your bills would actually be quite a bit lower. And this is okay. It’s fine to have an iPod. Just know that as an improvement to your lifestyle, it just really doesn’t fit into inflation proper.

  11. Absolutely it underestimates. CPI doesn’t include food, gas, housing and clothing. Guess what America spends its money on? I love that they say there isn’t massive inflation while they fill up their tanks with $4/gallon gas. Ridiculous

  12. I’m very un-impressed by the way inflation is general calculated. Particularly because I have a pretty nice sum in inflation-link bonds that never did very well. I definitely do not understand how only recently, maybe in the last year or so, have they gone up in value at all. I’ve had them since around 1999 and they hardly moved at all. Meanwhile, housing skyrocketed, taxes and everything else, not to mention oil prices as of late.

    And when you think of government jobs, and how they do take into account COLA raises — obviously someone knows when the cost of living rises — so why are their measures of inflation so inadequate?

  13. Heidi is right. Aside from the abstract variations in the formuals used to calculate CPI, one of the biggest ways to monkey with the inflation rate estimations is to so design the “contents of the basket” so as to achieve your desired result (or close to it). The standard excuse that I encounter for excluding things like fuel, food, and housing is that the price of these economic units is too volatile. However, the only good excuse for eliminating volatility like that is if you take for granted that the price fluctuations *always* trend back to a fairly unvolatile, predictable regression line. Since the fundamental global demand picture for food and fuel in particular has changed so dramatically, it’s certain that the “regression line” has shifted – for the long run. So it needs to be recalculated or the food and fuel prices need to be added back to the basket. The problem is that adding fuel and food into the CPI mix will (according to some calcualtion) yield a significantly larger than 1.1% jump.

    I’m also inclined to think that there are systemic motivations for government under-reporting of the actual CPI/Inflation levels. A higher inflation level would drive the value of the dollar down even further (although monitarists would argue the reverse that it’s the flood of leveraged liquidity that is pushing inflation up). Either way, lower $ value will motivate even higher prices for all kinds of goods and services – particularly the imported goods that we’re so fond of. In addition, a higher inflation level could force US T-Bonds to be downgraded – something that’s already been discussed. Many foreign and institutional holders of government bonds won’t hold less than AAA grade bonds, and a significant foreign selloff risks a domino effect of pain in the US economy. Not to mention that higher inflation rates will also inflate interest rates, and cause the few of us that still save and invest to see our alpha seeking efforts erroded. I could go on, but the point is that politicians are motivated to create quick fixes that get them through the next election. They understand clearly that voters don’t reward long term solutions (particularly when they involve short to mid term pain). So if tinkering with the CPI basket helps to hold all of this at bay for another election cycle or two, then said politicians find an economic think tank to justify it and they don’t have to think about it until the consequences of misallocated captial yields another set of shocks to the economy.

  14. On one hand you have UN talking about a global crisis caused by the surge in food prices, meanwhile the US gov’t chooses not to include food prices into core inflation. So whereas true inflation is about how much more we’re paying for the same goods today vs. yesterday, the CPI is merely a number that is managed and manipulated so it won’t be too shocking. If there was some other core product or group that pushed inflation substantially, better believe our government would find a way to remove that group from CPI calculation.

  15. Baba Ghanoush says

    For some reason, I thought that Social Security was based on average wage increases, not inflation rate. Am I wrong?

  16. Justjoeguy says

    If the Feds can’t even measure inflation accurately in the first place than how are they going to control it? The inflation rate is just somebody’s opinion. Since everybody’s situation is different everybody’s opinion is different. Therefore there is no inflation rate, just opinions about it.

  17. I measure inflation by wholesale prices. My professors in college taught me the CPI is a poor measure of inflation. Its used by the media to pump up data. When was the last time the media was pumped about a low CPI?

  18. Off-Topic:

    Congrats on being listed on the latest Money magazine as one of the best money blogs!! (P.120, May 2008)

  19. There is clearly a lot of misunderstanding about the CPI:
    1) The “headline” CPI-U _does_ include energy, food, and clothing. It includes rent but not the cost of buying a house above and beyond what it would cost to rent a similar house instead. This is for the same reason that it does not include stock market prices: it only tries to measure the prices of actual goods and services (including shelter “services”), not of financial assets. A house is both shelter and a financial asset and the BLS attempts to separate the two.
    2) The “core” CPI does not include food and energy. The core CPI is not used to set Social Security payments or anything else. It is used by academics because it has historically predicted future inflation better than the headline CPI which can bounce around a lot depending on oil prices. You may think that this relationship will not hold going forward but it historically has been true — that is simply a fact.
    3) The CPI does not substitute hamburger for steak and dog food for hamburger in order to bring down inflation. The CPI weights stuff by how much people spend on it. But it weights the items based on _last year’s_ purchases — so if you switch to hamburger, then it will still keep steak in the basket for another year. Then it updates to a new basket. If the CPI did not change the basket weights then we would still be measuring inflation using the prices of buggy whips and Chevy Novas. But if steak prices come back down and you switch back then the measured inflation will still lag. It’s called a Laspeyres index.
    4) You say
    “In addition, let’s say we go from using steak to hamburger due to price, and then back to steak again once it gets cheaper. Roundtrip, this substitution system would say that there was zero or even negative inflation during this time. But obviously prices actually rose. Just doesn’t sound right.”
    but if prices rose but then came back down then there was no net inflation! You would probably show a positive inflation one month and a negative the next and they would cancel each other out… what’s wrong with that?

  20. Somewhat on this topic is a new book titled “Bad Money”. One of ideas in the book is that the U.S. is following a typical pattern of a declining empire somewhat like the old European powers of the English and the Dutch, i.e. when they couldn’t produce goods their economies become based on financial services. A superpower can only rely on exporting financial services for a certain amount of time before collapsing and waning.

    Here’s a quote from an reviewer (very coincidental and timely):

    “Simply put, over the past 30-40 years, various administrations have changed the statistical bases of economic analysis. If consistent standards were used, inflation and unemployment would be shown to be much higher and the GNP much lower than we believe. We are losing the economic battle, but do not understand the extent to which we are because we have succeeded in lying to ourselves.”


  21. And if I haven’t said it enough times on this blog……..

    Bernanke is a big part of this problem. (imho)

    I’m just in awe of the way we’ve handled our economic situation. I don’t mean to sound extremist because I understand the idea that the feds job is to try & calm the storm…….BUT……..pouring sugar on a pile of crap doesn’t make it any less a pile of crap!!!!

    I truly don’t feel overly affected by inflation. To me, milk, food, clothing, etc. are still pretty cheap. Now the reason WHY they’re cheap scares me. (Levis made in Honduras, Fords made in Mexico, etc.) Technology is definitely changing the game. $100 cell phone bills. $100 cable bills. But, of course those service and the representative products involved w/ them are improving…….(iPhone, DVRs, etc.)

    My property taxes are protected by Prop 13 here in Cali, so I can even play the flip side of inflation in my favor. Hey, go ahead, spike inflation……my taxes will mean even less to you, Awnuld!!

    If anybody knows who Tom McClintock is……we need HIM for President!!!!!!!

  22. Ted Valentine says

    Jesse is correct. I counsel people with their budgets. People making 30k-40k a year are basically f—ed. There is nothing they can do when gas and groceries cost so much. They have to spend everything they have on basic needs. And their employers are not giving them raises to keep up.

  23. I don’t buy the inflation conspiracy theories for three reasons. 1.) The government doesn’t own the data sources. They are public sources of data available to everybody. The government doesn’t own them nor do they make them up, so that vastly reduces the possibility the government is manipulating the data since there is so much peer review going on. 2.) The government did not invent the process, academia did. Economists and statisticians mostly agreed this is the way to go. The process wasn’t thought up by the government, so that vastly reduces the chances the government could manipulate the numbers dishonestly even if they wanted to. 3.) These numbers are peer-reviewed by countless independent sources and they all come up with the same numbers. The shadow stats guy doesn’t reveal his sources. Curious, isn’t it? The Clinton Era method was simply incorrect. It was mathematically inaccurate and needed to change. Any competent statistician will tell you that. For the record, substituting hamburger for steak DOES count as a loss of quality under the current criteria and futhermore, whether or not you have no choice is irrelevant. If the quality of a product goes up the same as price, it’s not inflation regarldess of whether or not you have no choice.

  24. toastyaroma says

    the answer to the title of your article: yes.
    real inflation is now around 10% a year.
    The dollar has dropped 50% against the euro in 8 years.

  25. A handful of responses tell me that someone must not shop too often for groceries.

    Kyle: John Williamns of, calculates inflation the way it was done in the 1970’s. He also helps corporations improve their models for economic planning that takes the phony numbers from government. So, there is no mystery how he comes up with his numbers.

    Here is a recent interview with John Williams. Well worth the listen.

  26. It appears that you have things backwards in your logic of inflation. Let me help:

    1. High prices do not cause inflation.
    2. High prices are a RESULT of inflation.

    So, what is inflation? Simple.

    Inflation is the increase in the money supply.

    When the Fed decides to create money out of thin air, they inflate the money supply. This eventually causes higher prices since every dollar is worth less and less as the Fed creates more and more “money.” If the dollar was backed by a commodity (like gold or silver), then we wouldn’t have the side effects of inflation because the paper money would be redeemable for a fixed asset.

  27. Yes I think government around the world publish grossly under-estimated inflation figures! I know CPI derives from prices (of a basket of whatever) today relative to some benchmark some years ago but for example in Hong Kong, published 5-6% is complete horse shit. Everything from cup of coffee from Starbucks to a pair of pants, lunch box, to real estate it’s more like 20-30%.

    Please don’t try tell me about armies of highly paid economists/quants/PHD’s looks after CPI calc, if you’ve worked with some of these weirdo before you know multi billion hedge funds hires quite stupid people who’re highly qualified but with no common sense at all.

    This said, I haven’t actually reviewed, for example, how CPI published from HK Census department is calc, what constitues the basket – This much I know, it does not reflect real inflation AT ALL!!

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