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Understanding the Consumer Price Index

Published 29 Sep 2020

There are few economic assessments that impact our lives more than the subtle methodology changes used to calculate inflation through the Consumer Price Index.

Consumer Price Index (CPI)  heavily influences the level where central banks, such as the US Federal Reserve, set benchmark interest rates. This impacts cash deposit rates as well as bond and equity market valuations. 

CPI also impacts the rates used to determine wage and pension growth, which are usually indexed against CPI.  

The CPI was traditionally calculated by comparing the cost of a standard basket of consumer goods over time. A fairly simple exercise, right? Unfortunately, it’s not. Through the 1980’s central banks and governments saw a significant problem with this approach.

Following high inflation in the 1970s, governments realised that high CPI measurements impacted rates at which government’s borrowed money. It also greatly increased government outlays for both wage and pension payments. 

Economists began to tinker with the CPI’s calculations during the 1980’s and 1990’s, introducing changes that assumed consumers would elect to buy cheaper items as prices rise (e.g. switch from steak to chicken), and lowered prices to reflect technology improvements in items over time. (e.g., an old car vs a new one). Whilst actual purchase prices rose for consumers, continual adjustments to methodologies used to create the CPI, particularly over the past 30 years, has resulted in reported price inflation of just 2.4% per year.

If we use gold as an alternate measure of monetary inflation, we see a much higher rate of monetary inflation at 5.8% since 1990. This under-reporting has had an enormous impact on workers’ wages. For example, if we take an average Australian worker, an 2.4% increase in wages (in line with the reported CPI), results in a 100% salary increase after 30 years. If we instead use gold’s monetary inflation measure of 5.8%, the same worker’s wages would rise 600% over the same 30-year period. 

The problems appear more acute in the US. Work undertaken by the Chapwood Index[1] and John Williams[2] has rebuilt data for the original CPI basket back to the 1970s to help investors better measure how monetary inflation is impacting their purchasing power. Their work indicates that annual US urban inflation is 10-15% across large US cities, seriously challenging the validity of the US Fed’s reported CPI of 1-2%.

Rethinking asset allocation

Faced with extreme uncertainty, it is our view that investors should ensure that each investment decision offers sufficient return to counter the purchasing power loss occurring as a result of central bank monetary policy.





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