Via Wolf Street

An arcane device that impacts so much and papers over the struggles many Americans face in a world that is becoming increasingly unaffordable for them.

This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:

For anyone alive today, the US dollar has nearly always lost purchasing power with regards to consumer goods and services, such as food, cars, healthcare, or rent. There were a few brief periods when the dollar gained in purchasing power. But those periods are rare. And the Fed despises these situations when workers are able to buy a little more with the fruits of their labor.

In my lifetime, there were only two such periods, from March through October 2009, and a teeny-weeny bit during the oil-bust of 2015, when energy prices collapsed. During my lifetime, the dollar has lost 90% of its purchasing power. That’s the Fed’s plan, as long as it happens within certain limits.

Now, all this is according to official inflation figures, the Consumer Price Index, or CPI, put together by the Bureau of Labor Statistics. The CPI is critical because it is used for inflation-adjustment purposes across the spectrum, such as inflation-indexed Treasury securities, measures of “real” wages, cost-of-living adjustments for Social Security benefits, or measures of “real yields” or “real returns” on investments or “real” GDP.

But when goods and services get more expensive – and that’s what we’re talking about here – there are two factors involved:

One factor is that the dollar loses its purchasing power, meaning it takes more dollars to buy the same thing over time. A cut at a barbershop used to cost me $15 some years ago. Now at one of the few surviving pure barbershops in San Francisco, a cut is $30. This is inflation, a monetary issue, the change in the amount of dollars it takes to buy the same goods or services over time.

The other factor when goods and services get more expensive is that the quality improves. This is not a monetary issue. And there have been big quality improvements in products such as consumer electronics, cars, appliances, housing even.

These quality improvements are figured into CPI via the so-called hedonic quality adjustments. They’re supported by academic research, and they make sense on a conceptual basis. But when the resulting CPI is used to officially portray increases in the actual costs of living, that’s where everything gets screwed up.

In 1990, the base Camry LE with a four-cylinder engine and automatic transmission came with a Manufacturer’s Suggested Retail Price, or MSRP, of around $14,700. The current 2020 base Camry LE with a four-cylinder engine and automatic transmission comes with an MSRP of $25,000. That’s a price increase of 70% from 1990.

But over the same period, the Consumer Price Index for new vehicles – so this is one of the many subcategories of CPI – has risen only 22%. In fact, it rose 22% from 1990 to 1997, and today is flat with where it had been in 1997.

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Obviously, no one pays MSRP. Automakers pile on rebates and incentives, and dealers give discounts. But they also did that in 1990. So MSRP serves as a reference point.

In 2018, the base price of the Camry LE jumped by nearly 5% from the prior year. Toyota figured it would get away with it because it had redesigned the 2018 Camry. The appearance changed. It got longer and wider. Aerodynamics improved. It got more horsepower and torque, new standard features, etc. But in the years before the redesign, the base price remained nearly flat.

On a product-by-product basis, many price increases come in bursts, followed by periods of no price increases.

Toyota jacked up the price of the Camry in 1992, 93, and 94 by 6% to 11% each year, until the base price was very close to $20,000. And that’s where it got stuck. Toyota likely saw resistance in the market, and the price kept bumping into the $20,000 ceiling until, in 2006, it finally broke through.

Then from 2006 through the current model year, prices jumped by 25%. Over the same period, the CPI for new vehicles rose about 4%.

In fact, between 1997 and 2008, the CPI for new vehicles fell by 9%. Then starting in 2009, it rose again and today it is back where it had been in 1997. Meaning zero inflation in new vehicles since 1997.

This discrepancy between actual price increases of new vehicles, and a declining or flat CPI for new vehicles is in part the result of the so-called “hedonic quality adjustments.”

The CPI does not attempt to track by how much the costs of living rise. It attempts to show by how the price of the same thing or service changes over time, to measure a monetary phenomenon, the loss of purchasing power of the dollar.

So in 1990, the Camry LE came with a four-speed automatic transmission and maybe one or two airbags. Today’s model comes with an electronically regulated, shiftable eight-speed automatic transmission and ten airbags. And it comes with myriad other improvements and safety features that were unheard of in 1990, like a backup camera so you don’t run over your dog sleeping behind the car.

These improvements come with additional costs, and estimates of these additional costs are removed from the CPI calculations as they occur over the years. These are the “hedonic quality adjustments.”

The theory is that the vast majority of that 70% price increase of a Camry since 1990 is due to quality improvements, with buyers today getting a far superior Camry; and that only a smaller part of that 70% price increase is due to monetary inflation, namely the dollar losing its purchasing power.

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But consumers can no longer buy a new 1990 Camry. If they buy a new car, they have to buy these quality improvements. And they have to pay the price for them. The CPI for new vehicles weighs about 3.7% of the overall CPI.

This principle applies to other product categories as well, such as used vehicles. The CPI for used cars and trucks has declined by 11% since 1995, while the actual prices have surged. Used cars and trucks weigh 2.4% in the overall CPI.

The CPI for computers, peripherals, and smart-home devices has plunged by 75% over the 14 years between 2005 and today. Computers and other electronic devices have gotten a lot more powerful, with a lot more memory and storage space, and numerous new features, while prices have declined.

The CPI for telephone services – so this is your cellphone or landline bill – has dropped 11% over the past 20 years. You may well pay more for your cellphone bill than you did in 1999, but you’re getting a lot more too, whether you want it or not. Now you have a supercomputer in your hand with broadband data access to the internet. Telephone services weigh 2.2% in the overall index.

Housing is the biggie. The category shelter includes rents and owner’s equivalent of rent of residence. Shelter weighs one-third of total CPI. Improvements in heating and AC systems, appliances, kitchen and bathroom fixtures and finishes, safety features, alarm systems, smart devices, energy efficiency, etc., are all quality improvements that occur over time, and estimates of those costs are removed from the CPI of housing costs.

In addition, it could very well be that the costs of the quality improvements have been systematically over-estimated, and as these systematically over-estimated costs are then removed from CPI, inflation as measured by CPI would be systematically understated.

So we get this two-fold situation: CPI measures monetary inflation, namely the dollar loses purchasing power.  But the actual costs of living – what people pay on a daily basis to get through life – increase far faster than monetary inflation because people are also paying for the quality improvements, whether they want to or not. And so life gets relentlessly more expensive.

For this reason, CPI should never be considered a measure of cost-of-living increases. But that is precisely how it is being used. And that’s the problem.

For example, the cost-of-living adjustments, or COLAs, for Social Security benefits are based on CPI. But the actual increases in the costs of everyday life due to these quality improvements far outrun monetary inflation. And this has the effect of pauperizing people on Social Security, even those who were OK-ish during the first few years of receiving benefits, but 20 years down the road, their living conditions have become miserable.

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Calling these inflation adjustments to Social Security quote-unquote “cost of living adjustments” is an official lie designed to fool people.

CPI is also used to adjust household incomes and wages and GDP and everything else for inflation.

For example, full-time male workers’ wages, when adjusted for inflation via CPI, so their so-called “real wages,” have been flat since the 1970s, according to Census Data. Full-time female workers’ real wages have grown over the period, but from a much lower base. And due to the real-wage growth for female workers, overall real wages have grown a little.

But this overall number hides the fact that men’s real wages are still flat with the 1970s, and that these men are facing a world where the actual costs of living have risen far beyond the pace of CPI, largely due to the hedonic quality adjustments.

These folks are immensely frustrated because they’re living in a world that is becoming increasingly unaffordable for them, while the official CPI data artfully papers over it.

The problems spread to investments. For example, when a stock-market index is adjusted for inflation, it only removes the effects of monetary inflation. Government bond yields and interest on savings products are already largely below the rate of inflation as measured by CPI. Going up the risk curve with corporate bonds, yields exceed monetary inflation. But they may still not keep up with the actual increases in the costs of living.

And that modest nest egg plus Social Security that are supposed to get people through retirement, if any, may turn out to be a lot skimpier 10 years into it than people think, because life has gotten a lot more expensive than CPI indicates.

Conceptually, it makes sense to remove the costs of quality improvements from monetary-inflation indices to track the decline in the purchasing power of the dollar. The result is something like CPI.

But when CPI is stretched to pretend that it portrays the increases in the actual costs of living, it is used in cold blood as a blatant lie.

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