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Inflation

Copyright © 1998-2000, 2003-2010 by David E. Ross

In planning for my retirement, one important factor I considered is how inflation impacts both my pre-retirement income — which determines my future Social Security benefits, my employer's pension benefits, and how much I can afford to invest — and my need for post-retirement income. I hear on the news about inflation, but I never hear how it is measured. Therefore, I created my own measure — something tied both to the national economy and to the local cost of living.

To measure inflation, I use both the consumer price index (CPI, which tracks how much money I will need to maintain some standard of living) and the producer price index (PPI, which tracks the underlying costs of bringing goods to the retail market). I obtain these from the U. S. Bureau of Labor Statistics (BLS).

I view both current inflation (over the past 12 months) and long-term inflation (over the entire period in which comparable indices are available).

• Current inflation is generally considered by employers when trying to establish competitive compensation rates. It is also a baseline against which to evaluate whether investment returns are appropriate. Cost-of-living adjustments in Social Security taxes and benefits are based on current inflation. I measure current inflation by considering year-to-year changes in the indices, thus eliminating any fluctuations caused by seasonal availability of fresh foods, seasonal demand for fuel, etc.
• Long-term inflation is of primary concern when determining the adequacy of retirement savings. This also eliminates any effects of short-term spikes or troughs in economic activity.

Living in southern California, I am affected by local economic trends in Los Angeles. Thus, besides considering national indices, I also consider the local CPI for Los Angeles. For those not living in this area, the table below includes the latest month's national inflation based on the same methodology that I use for local inflation.

The graph below plots recent values of current and long-term U.S. inflation.

Methodology

Current Inflation is computed from non-adjusted indices over a one-year span (i.e.: to the report month from the corresponding month in the prior year). By using year-to-year data, I eliminate the need for seasonal adjustments, which are sometimes questionable.

Long-Term Inflation (except for the CPI-LA index) is computed from non-adjusted indices from 1 July 1983 (mid-point of the base period of index definition) with an assumed value of 100.0 at that epoch. For the CPI-LA index, the computation is from 28 February 1969 with a value of 36.0, which the BLS told me (in the early 1980s) was the equivalent value of the current index at the base month for the prior index (which until then I had been tracking). For all three indices, I use the rate that would yield the current value if compounded annually from the base period.

In July 2008, I changed the computation of LA Infl values when I noticed a very large increase in the PPI caused the local rate of inflation in the Los Angeles metropolitan area to be smaller than the national rate of inflation even though the CPI-LA index had a larger increase than the CPI-US index. Obviously, this was wrong. I now use the following:

• US Infl is computed by multiplying the inflation factors (1 + percentage), taking the square-root of the product), and subtracting 1. This is the geometric mean of the PPI and CPI-US.
• LA Infl is obtained by first computing the geometric mean of the CPI-US and CPI-LA factors. The result of that is then used with the PPI inflation factor to compute a new geometric mean. I combine the national and local CPI values because, while local prices determine much of the local cost of living, many consumer goods are now purchased non-locally through the Internet and catalogues.
• Combined is obtained by computing the geometric mean of current and long-term inflation.

I use geometric means because they are usually a better representation of the "average" of percentages than the more common arithmetic means.

The PPI index (WPU00000000) is for all commodities. Generally, this is initially reported as preliminary and subject to revision. My tabulation is not revised if the final value does indeed change.

The CPI indices are for all urban consumers for all items. The CPI-US index (CUUR0000SA0) is the U. S. city average. The CPI-LA index (CUURA421SA0) is for Los Angeles, Orange, and Riverside Counties in California. It was suggested that I use CWUR0000SA0 and CWURA421SA0, which include housing components, instead of CUUR0000SA0 and CUURA421SA0, which do not. However, the CWUR series are for "Urban Wage Earners and Clerical Workers" and thus exclude spending patterns of the self-employed, salaried workers, and retirees. The CUUR series are for "All Urban Consumers". The CUUR series is thus more reflective of my own situation — formerly salaried and now retired. The omission of housing components from the CUUR series has negligible impact on my situation since I have owned my house for over 35 years and do not plan to move.

Manipulating the Indices

The BLS is an agency within the Department of Labor, part of the President's cabinet. Thus, there are occasional pressures to "adjust" the indices for political purposes.

The most frequently discussed adjustment for the CPI is substitution. This involves monitoring how consumers change their spending habits in response to inflation, changing the way the CPI is computed accordingly. For example, if the rising costs of food mean that we are forced to eat more hamburger and less steak, the significance of steaks in the CPI is reduced while the significance of hamburgers is increased. As a result, the CPI does not rise as much. This manipulation would hide the degradation of our standard of living caused by inflation.

Such manipulations are not the only way politics becomes involved with the indices. The President's administration (all Presidents, not merely the current one) will sometimes select the most favorable index when discussing the nation's economy. Thus, during soaring prices for food or fuel, only the core CPI (which omits those two items) is mentioned. During a decline in the real estate markets, the CWUR CPI series is cited because it makes inflation appear less; conversely, during a real estate boom, the administration may tend to cite the CUUR series, which omits the inflationary impact of rising housing costs.

An article on the front page of the Los Angeles Times "Business" section on 20 May 2010 raised the spectre of deflation. It cited a month-to-month (March to April 2010) decrease of 0.1% in the CPI and a year-to-year (April 2009 to 2010) increase of 0.9%. From March 2010 to April 2010, however, the CWUR0000SA0 increased 0.2%; the year-to-year increase was 2.24%. Both of those CWUR0000SA0 changes clearly did not indicate deflation. The statistics in the Los Angeles Times article were taken from a BLS press release in which core CUUR CPI changes were reported after seasonal adjustments. Thus, the article fostered fear over deflation by citing statistics that are doubly flawed: they involve highly subjective seasonal adjustments and they omit food and fuel costs, which are among the most significant recurring expenses for consumers.

There is no perfect measure of inflation.