An Alternative Inflation Index

By: George J. Paulos | Wed, Sep 8, 2004
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I have long been a strong critic of the US government's reporting of price inflation. I claim that the government statistics significantly understate the true inflation rate but I have not been able to back up my criticism with any real hard data due to the lack of an alternative inflation gauge. The lack of alternate data inspired me to create my own inflation index using price data from my own memory, the internet, old receipts, and old catalogs to see how it compares to the official inflation figure.

Inflation is a personal experience with a slightly different effect on each individual depending on his or her particular mix of consumption, locality, and ability to find a bargain. However, these differences tend to even out over time so the most effective measurement is over a long sample period. To construct the index, I recovered the average price for a variety of products and services from 1968 and compared them to the same item today.

1968 is an important year because it represents a transition from the stable prices of the previous decades to the Great Inflation years of the 1970s. Interest rates were just starting to rise above long-standing norms and prices were starting to take off. The international gold standard started unraveling in 1968 with introduction of a two-tiered gold price system that ultimately led to total abandonment of the gold standard several years later. 1968 represents the beginning of a series of price adjustments that pummeled the buying power of the US dollar.

Methodology

The Freebuck.com Inflation Index is an average of price components that is weighted and categorized in approximately the same manner as the official Consumer Price Index. Housing represents the largest component at 40% with other categories having lesser impact. The inflation rate is calculated as a price multiplier with a base year of 1968 which represents the number of 2004 dollars that are required to purchase what $1 bought in 1968. The annualized inflation rate is the equivalent average compounded yearly inflation rate over the 36 year period. Prices were selected to be representative of the times, not necessarily exact price quotes. To make the price comparison meaningful, index components were selected that are similar in function and quality in both time periods. No hedonic adjustments for quality changes have been made. Some prices were unique to my home state of Minnesota where national data was unavailable. Components were selected to be representative of that product or service category. Of course, much is excluded to keep the index simple.

Browse the Index components and if you are old enough to remember, ponder how prices have evolved over 36 years.

The Freebuck.com Inflation Index

Component 1968 Price 2004 Price Multiplier Weight
 
Housing       0.4
Average US Home Value $26,000.00 $260,000.00 10.00 0.25
Non-Farm US Rent Index 21.00 111.00 5.29 0.12
Natural Gas retail per MCF $0.55 $9.80 17.82 0.02
Electricity retail per KWH $0.02 $0.07 3.26 0.01
 
Transportation       0.17
Chevy 4-door Sedan base sticker $2,800.00 $17,000.00 6.07 0.09
Gasoline $0.33 $2.00 6.06 0.07
MTC Bus Fare $0.20 $2.00 10.00 0.01
 
Food&Beverage       0.15
Loaf of Bread $0.25 $2.50 10.00 0.01
½ Gallon of milk $0.55 $2.60 4.73 0.01
Dozen large eggs $0.55 $0.99 1.80 0.01
1lb bacon $0.69 $4.59 6.65 0.01
1lb skinless wieners $0.59 $2.88 4.88 0.01
Head iceberg lettuce $0.19 $0.99 5.21 0.01
1lb red Alaska salmon $0.88 $6.48 7.36 0.01
46oz Welch's grape drink $0.49 $2.65 5.41 0.01
Large Snickers candy bar $0.15 $0.99 6.60 0.01
McDonalds regular burger $0.20 $0.85 4.25 0.01
McDonalds Big Mac $0.49 $2.65 5.41 0.01
Cup of coffee $0.20 $1.25 6.25 0.01
Vending machine Coke $0.10 $1.00 10.00 0.01
Pack of Marlboro Cigarettes $0.50 $3.50 7.00 0.01
Tap beer at "Ted's Bar" $0.25 $2.50 10.00 0.01
 
Apparel       0.05
Men's blue jeans $4.00 $24.00 6.00 0.01
Men's work boots $20.00 $135.00 6.75 0.01
Dress Leather Belt $2.50 $20.00 8.00 0.01
Nylon Lined Fall Jacket $10.00 $50.00 5.00 0.01
Lined Winter Gloves $4.00 $20.00 5.00 0.01
 
Education&Communication       0.06
University of Minnesota cost per credit $8.25 $183.00 22.18 0.05
Time Magazine cover price $0.50 $3.95 7.90 0.005
Minneapolis Star daily newspaper $0.15 $0.50 3.33 0.005
 
Recreation&Entertainment       0.06
19" color television $399 $149 0.37 0.01
Crosby Stills Nash Concert Ticket (1969) $5.00 $60 12.00 0.01
Crosby Stills Nash Record Album (LP & CD) $3.19 $13.99 4.39 0.01
MN Twins baseball general admission ticket $3.00 $20.00 6.67 0.01
First-run movie ticket $1.00 $8.50 8.50 0.01
Parker Bros Monopoly Game $4.00 $15.00 3.75 0.01
 
Medical Care       0.06
Consumer Medical Expenditures Price Index 13.76 109.80 7.98 0.03
Medical Insurance Index 5.31 100.00 18.83 0.03
 
Other Goods&Services       0.05
Men's Haircut $2.00 $20.00 10.00 0.005
Gibson Les Paul Standard electric guitar $400.00 $3,000.00 7.50 0.005
GE 22'cu Refrigerator $430 $1,130 2.63 0.005
Sears self-propelled rotary lawn mower $119.00 $319.00 2.68 0.005
1 gallon latex paint $8.00 $22.00 2.75 0.005
Sears Craftsman 15" floor drill press $139.00 $399.00 2.87 0.005
9V transistor battery $0.35 $3.00 8.57 0.005
First Class Postage Stamp $0.05 $0.37 7.40 0.005
35mm Color Film 24exp $5.50 $5.50 1.00 0.005
12" cast iron skillet $3.40 $15.00 4.41 0.005
 
Average Freebuck.com Price Multiplier 8.41
Annualized Freebuck.com Inflation Rate 5.96%
Official 1968 US CPI price multiplier 5.43
Annualized CPI inflation rate 4.71%

*The Medical Insurance index was calculated from US Gross Personal Expenditures on medical insurance premiums adjusted for population growth with a base year of 2004.

Findings

Conclusions

This index is composed of two snapshots in time 36 years apart. As such, this is a long-term measurement and does not necessarily apply to year-over-year comparisons. Much has happened to the relative pricing of the components during that period. Gas prices rose sharply and collapsed. Stock and gold prices went through bull and bear markets. Even real estate had several serious hiccups along the way. I find it extraordinary that real estate, stocks, and gold in 2004 are at the same relative valuations as they were in 1968 considering the wild ride in between. These are core asset markets whose value is determined by fundamental economic forces. This convergence leads me to believe that there is something unusual about this period in time.

A higher reported inflation rate has important consequences for the economy. Real growth rates and real living standards are calculated by taking raw (nominal) economic data and adjusting by the inflation rate. If we calculate the raw non-adjusted GDP growth from $880 billion in 1968 to $11450 billion in 2004, we get a nominal GDP growth factor of 13.01. Divided by the new Freebuck.com inflation factor of 8.41 we get a real growth factor of only 1.54. During the period from 1968 to 2004 the US population grew from 200 million to 292 million, a factor of 1.46. Therefore real per-capita economic growth was essentially flat during this entire era using the updated inflation figure.

Let's look at the data from the perspective of income growth. Total unadjusted US wages and salaries grew from $465 billion in 1968 to $5249 billion in 2004, a growth factor of 11.29. If we divide by the population growth factor of 1.48, we get a nominal per-capita wage growth of 7.62. This means that if we use the Freebuck.com inflation rate, real aggregate personal income was negative during the last 36 years because prices rose faster than wages.

The aggregate per-capita income figures stated above apply to the population in general, both working and non-working. We now have a much greater percentage of the adult population working as shown by the civilian labor force which grew by a factor of 1.91. This means that per-worker income growth (real individual wages and salaries) is in decline. In fact real wages have dropped substantially using the new inflation calculation. This result validates the widespread belief that two incomes are now needed to provide a family with an adequate standard of living.

The chart below shows several core economic statistics when adjusted by both the official CPI rate and the Freebuck.com rate. This chart should perhaps be titled "The US Economic Hall of Shame". It shows that per-worker real wage growth has been negligible even when using the official CPI figure. The Freebuck.com inflation figure shows that real wages have fallen substantially.

36 Years of Real US Economic Growth
  Official CPI Rate Freebuck.com Rate
Real Economic Growth (GDP) 139% 54%
Per Capita Real Economic Growth (GDP) 62% 3%
Per Worker Real Economic Growth (GDP) 25% -19%
Real Wages and Salaries Growth 108% 34%
Per Capita Real Wage Growth 40% -9%
Per Worker Real Wage Growth 9% -30%

The chart above is a big reason why the government would try to obscure the true dimensions of the inflation problem. Any widespread belief that inflation and economic growth are improperly reported would have dire consequences on the financial markets and the political environment. I believe that understating the inflation rate is a politically motivated policy that is in place to enable the government to continue to undermine the currency while buying votes through false economics.

Although necessarily limited in scope, the Freebuck.com Inflation Index strongly implies that the official rate is too low. As a consequence, it also suggests that economic growth has been far more sluggish than the official figures show. This lack of growth is expressed in the burgeoning US total debt. We see exploding debt levels in every part of the economy as consumers, businesses, and governments struggle to maintain stability under the slow-motion collapse of their currency. The failure of average wages to keep up with inflation is further evidence of lackluster per-capita economic growth. This new inflation estimate also supports my intuition that blue chip stocks and real estate have performed only slightly better than real inflation over the last few decades and have added little to the wealth stock of Americans.

The Freebuck.com Inflation Index shows how easy it is to "manufacture" an inflation rate. With the wide variety of different products showing wildly different inflation rates, I could have chosen a different mix of components or weighting to deliberately skew the inflation rate either up or down. The official CPI is a complex measurement of hundreds of products and services that are weighted according to a formula that "hedonically" adjusts prices to reflect quality improvements. Such a methodology is highly vulnerable to honest biases as well as deliberate falsification.

This inflation analysis paints a picture of the past that is far less vigorous than the general consensus. Because this is a long-term study, it does not necessarily mean that the future will be like the past. That depends on future events and decisions that are not yet made. I believe that more and more investors are coming to the conclusion that inflation is much higher than the official statistics. This will have important consequences for future inflation. If bond investors feel that they are not being adequately compensated for loss of purchasing power, then they will force interest rates higher. This will have the effect of reducing inflation and unfortunately also economic growth. The financial markets have a lot of power to influence the future course of inflation. It all depends upon the consensus perception of inflation reality. This article is an attempt to alter that perception.

The results shown here about inflation beg the question "Are other government economic statistics also faulty?" In an excellent report by Gillespie Research, Walter J. Williams writes: "As a result of the systemic manipulations, if the GDP methodology of 1980 were applied to today's data, the second quarter's annualized inflation-adjusted GDP growth of 3.0% would be roughly three percent lower (effectively netting to zero percent or below). In like manner, current annual CPI inflation is understated by about 2.7% against the pre-Clinton CPI methodology (would be about 5.7%), and the unemployment rate is understated by about seven percent against its original design and what many people would consider to be actual unemployment (would be about 12.5%)."(link) Williams shows in his report how important economic statistics have been periodically restructured to meet the political needs of those in power. These revisions always make the numbers look more optimistic than reality. The tragedy is that politicians come and go but corrupted statistical methods remain in place long into the future. The net effect of these statistical manipulations is to gradually weaken the quality of reported statistics over time.

Good decision making by political and business leaders requires good information. As the quality of information declines, so does the quality of leadership. Critical decisions such as the proper level of interest rates, money supply, and cost-of-living adjustments are being made with faulty data that could lead us into crisis, if they have not done so already. It is of the utmost importance that the investment community puts pressure on the authorities to fix the flaws in their economic reporting. In this spirit, I invite readers and other analysts to compile their own Inflation Indices. Any readers who do perform this exercise are welcome to send their results to me. If I receive enough feedback, I will publish reader inflation statistics in future essays in an effort to continue this dialog and alert others about this problem.

I fervently hope that the next 36 years does not generate the same inflation as the last 36. Imagine a young adult planning for retirement with the burden of saving enough to make up for an eightfold increase in the cost of living while real wages keep dropping. If the huge inflation in education cost continues, how will new parents pay for their child's education when college will cost five times what it does today? Investing under such conditions is extraordinarily difficult. Investors would have to assume significant risk to stay ahead of such massive inflation. Buy-and-hold is not an option. Investors would have to carefully assess intermediate-term trends and place capital accordingly. Few investors beat the averages and the averages just barely beat inflation over the very long term.

Special thanks to Jim Willie of the Hat Trick Letter for his assistance with this analysis.


 

George J. Paulos

Author: George J. Paulos

George J. Paulos
Freebuck.com

George J. Paulos is Editor/Publisher of Freebuck.com, a website devoted to wealth preservation and enhancement using alternative investing approaches including precious metals. He is also Associate Editor of The Gold Letter, a newsletter covering junior mining and natural resource stocks.

The information contained herein is deemed reliable but no guarantee is made about its completeness or accuracy. The reader accepts this information on the condition that errors or omissions shall not be made the basis for any claim, demand or cause for action. Any statements non-factual in nature constitute only current opinions, which are subject to change. The author/publisher may or may not have a position in the securities and/or options relating thereto, & may make purchases and/or sales of these securities relating thereto from time to time in the open market or otherwise. Neither the information, nor opinions expressed, shall be construed as a solicitation to buy or sell any stock, futures or options contract mentioned herein. The author/publisher of this letter is not a qualified financial advisor & is not acting as such in this publication. Investors are urged to obtain the advice of a qualified financial & investment advisor before entering any financial transaction.

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