How Inflation Is Being Understated and Why What’s Coming Is Worse Than Expected

A customer shops for meat at a Safeway store in San Francisco, California on Oct. 4, 2021. Justin Sullivan/Getty Images

Commentary

Last week, we wrote about why inflation is a threat to your portfolio, and in today’s article we’re going to cover how inflation is being understated and why we believe that things are going to get worse. Next week, we’ll cover a variety of ways readers at all levels of income and wealth can take steps to protect themselves.

The Consumer Price Index (CPI) is an attempt to measure an overall increase in prices across time. The calculation runs into a variety of problems including issues with product substitution, rural vs urban consumption, and innovation. The last item shows how difficult it is to calculate an inflation number when prices for items like cars, televisions, and computers might be similar to what they were many years ago, but the newer models have better performance and improved features. If you pay the same amount for a better product, the CPI doesn’t reflect that.

Food, energy, and housing are particularly difficult to evaluate as lower income families pay a much greater percentage of their income for those items than wealthier families.  This is further complicated by the reporting of Headline and Core CPI numbers where Core CPI excludes food and energy. With appropriate sympathy and respect for the economists who try to make these calculations accurate, the way the CPI is calculated is designed to understate the real number.

The most obvious example is housing (referred to as “Shelter” in the official description). The U.S. Bureau of Labor Statistics just reported a 7.0 percent increase in the December CPI, which is a multi-decade high. That report listed the increase in housing prices at 4.1 percent.  However, when we look at the Case-Shiller U.S. National Home Price Index from the Federal Reserve Economic Data, it shows a 19.1 percent increase in the last twelve months and 29.1 percent in the last two years.

A Graph showing the increase in U.S. home prices over the last two years Source: S&P Dow Jones Indices LLC

So, housing costs went up 19 percent and the official CPI says 4 percent. That shouldn’t be possible. What’s happening is due to a sneaky change made to the CPI in 1998 when the shelter cost for homeowners was changed to “owners’ equivalent rent.” That means that homeowners were asked to estimate what someone would pay to rent their homes. Largely because homeowners rarely buy houses and even more rarely rent them, people tend to underestimate what it would cost to rent in their neighborhood. Since the change in methodology was put in place 24 years ago, owners’ equivalent rent has trailed actual housing prices by 67 percent.

A graph showing U.S. home prices rising faster than Owners’ Equivalent Rent Source: S&P Dow Jones Indices LLC

In general, the people in charge of the government have a tendency to make bad things like inflation look like less of a problem than they actually are. Using the new methodology allowed inflation reporting that was below the actual increase in cost of living. Because shelter makes up 33.3 percent of the CPI, if last week’s inflation number included the actual cost of housing, the CPI would have been up 12.1 percent instead of the reported 7.1 percent.

We’re also skeptical of the food calculation. The December CPI claimed that the price of food is up 6.3 percent in the last year. The Food and Agriculture Organization of the United Nations reports that worldwide food prices were up 23.1 percent in 2021. That sharp spike in the yellow line in the chart below shows what happened to food prices last year. We’d be surprised if the increase in U.S. food prices was only one-quarter of the change in worldwide food prices, and we’d be surprised if most of the readers of this newspaper are only paying 6 percent more for food than a year ago. Feel free to let us know in the comments if that’s been your experience over the past year.

A graph showing the increase in worldwide food prices Source: Food and Agriculture Organization of the United Nations

Last week, we covered how quantitative easing and low interest rates are the root cause of the inflation we’re experiencing now.  Last month, Federal Reserve Chairman Jerome Powell said he was going to wind down quantitative easing over the next few months and start to raise interest rates in 2022. With the Federal Funds rate currently at 0 percent and the official CPI at 7.1 percent, that means that real interest rates are currently negative 7.1 percent. We have a huge negative real interest rate, inflation at a multi-decade high, and systematic underreporting of inflation, and as of right now, the Federal Reserve is still increasing the liquidity in the system. Said plainly, they’re still doing more of the thing that’s causing the problem. The market is acting like Powell just insisted that everyone eat their broccoli, while he’s actually still handing out candy like it’s Halloween.

Even though the Fed has stopped using the word transitory to describe inflation, it’s clear they expect it to moderate later in 2022. Powell is in a tough spot. Inflation is crushing the savings of the people who have managed their finances carefully, and it is a danger to the standard of living of anyone on a fixed income or who isn’t affluent. In order to mitigate that problem, Powell is going to need to raise interest rates aggressively. If he does so, the stock market will likely take a hit. He’s trying to balance the stereotypical conflict between Wall Street and Main Street, but someone is going to get the worse end of this. As of now, he’s letting inflation rise quickly and protecting the stock market.

A lot of Americans are anxious right now about the state of their finances, the ability to maintain their standard of living, and about their savings and investment portfolios. Next week, we’ll address a list of things that people at every level of income and wealth can do to better protect themselves and their investments from both higher inflation, and the coming higher interest rates.