We interrupt the steady stream of stupid investments to bring you a stupid economic indicator that is trying to tell you about the way you...
We interrupt the steady stream of stupid investments to bring you a stupid economic indicator that is trying to tell you about the way you live … and which routinely misses.
When the wildly touted numbers for inflation and the Consumer Price Index are released each month, consumers take it as a matter of fact that the numbers represent the inflation hurdle they are faced with.
But for many people, the quoted inflation numbers are way off, by enough that they could lead to bad financial decisions, to where plans made to keep up with inflation fail because your financial situation is significantly different from the “average.”
The Bureau of Labor Statistics’ Consumer Price Index uses a flawed system to represent the “average consumer.”
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Economist Kamran Afshar explains the problem in terms of two guys playing golf, where the first one tees off and hooks a shot into a bunker 20 yards short of the green, and the second one slices a tee shot into the rough 20 yards behind the green.
“By the standards that are used to calculate inflation,” Afshar says, “the average of those two shots is a hole in one. … In fact, the average used to calculate inflation is very far off from the way most people spend their money.”
Despite that, consumers base their financial planning on those national inflation numbers.
They could benefit by being able to figure out just how inflation hits them at home, but there is no way to calculate rates for each individual household.
That’s why Afshar made one.
At my request, Afshar, who runs the economic research firm Kamran Afshar Associates in Bethlehem, Pa., broke down the CPI into its components, creating the chance for an individual to see how inflation hit home in their own household in 2007.
Here’s why individuals fall so far from the average.
The Consumer Price Index applies certain weights to each major sector of spending, so that it assumes that the average consumer spends 42.7 percent of their income on housing costs (including insurance, utilities, furnishings, rent or mortgage, etc.), 6.3 percent on medical care, 17.2 percent on transportation, 15 percent on food, 3.1 percent on education and so on.
But a retiree whose house has been paid off for years, whose kids are a generation removed from college, whose appetite has started to wane, but who is facing serious medical concerns will have an experience that is very different from the average.
Those medical-care costs face dramatically higher inflation — just over 5 percent — than the housing costs (where inflation was nearly flat in 2007), so that senior is likely facing inflation that is a full percentage point or more above average.
That’s a huge issue for someone living on a fixed income, particularly when that income stream was built around the CPI numbers for the “average person.”
Conversely, a young couple with a few kids could be spending a fortune on food, a good amount on clothes — where prices have actually been going down — on education. For them, the big issue might be transportation costs.
Afshar noted that there are several other factors that make it hard for the most prominent inflation measure to be accurate, most notably the fact that the prices are based on a 1982-84 base.
Imagine personal computers or home televisions of that era — big machines no longer available today — and you’ll have a quick handle on why there’s a problem (those technology items actually drive the cost of inflation down, even though it would cost you more money to replace your main household television today than it cost 20 years ago).
There’s also the “substitution” process; put simply, this holds that if the price of, say, carrots goes up, a consumer would simply substitute a different vegetable, like cucumbers, where the price is steady. That might work, unless the recipe calls for carrots, or the kids hate cukes.
“I don’t think the government wants people to know the numbers in their home … it would just increase their frustration,” says Jack Ablin, chief investment officer at Harris Private Bank.
“Having a better idea of how inflation hits you, however, would allow you to change your plans. A lot of retirees are relying on bonds to satisfy their living expenses, but when they really take a look at it, they may find that bonds aren’t going to cut it. … Better to know that now than when you just discover that you have a problem.”
While calculating your personal inflation rate is helpful for planning purposes, Afshar noted that CPI also tends to vary from one region to the next (think heating and cooling costs, for example), and that some regions are consistently more expensive or cheaper, which is ignored in the CPI numbers (and, thus, in the personal rate calculations).
“What would be best is if consumers had access to this information, so that they could use it to plan for real inflation,” Afshar said, “but this information is the next best thing. If you don’t know the real inflation rate in your home, then all you can rely on is the [government] numbers, and then hope that you are lucky enough so that your experience is somehow close to that average.”