(Mike Maharrey, Money Metals News Service) If your policy can’t drive inflation down, just revise the methodology to make it seem lower.
This seems to be the federal government’s strategy.
The Bureau of Economic Analysis (BEA) has revised the Federal Reserve’s favorite inflation gauge to understate inflation just a little bit more.
When measuring inflation, most economists and the financial media tend to rely on the Consumer Price Index (CPI) calculated by the Bureau of Labor Statistics. However, the Fed prefers the BEA’s Personal Consumption Expenditures (PCE) Index.
The two price inflation measures rely on significantly different methodological approaches, and central bankers prefer the PCE because it tends to understate price inflation more than the CPI.
Instead of asking consumers what they buy, the PCE compiles data based on what businesses sold. BEA analysts compile information from a wide range of sources, including Census Bureau retail surveys, manufacturer shipment data, hospital and physician revenues, utility revenues, airline ticket sales, financial service companies, and other business and government data.
To calculate the PCE index, BEA analysts track prices in specific categories, including food, healthcare, and housing. They combine these price changes and weight them based on spending within each category. For instance, if food spending is higher than healthcare, the food category will be weighted higher.
The BEA then uses a “Fisher chain-weighted” formula using purchasing patterns from both the current and previous periods. The weights shift as consumer patterns change. For example, people might buy more chicken if beef becomes more expensive. This “chain-weighted” method links successive price changes together to measure inflation over time.
It’s a complex formula. According to the BEA, the Fisher formula takes the geometric average of prices in earlier and later periods –multiplying them and taking the square root. This accounts for changes in purchasing patterns instead of relying entirely on a fixed basket of goods and services, as the CPI does. “Chain-weighted” means each period’s comparison links to the next, forming a continuous measure of price changes over time.
A Change in Methods
On September 30, the BEA changed how it measures prices in three PCE categories to “improve deflation.” In other words, the agency hopes the updates will better separate price changes from changes in the amount or quality of goods and services consumed.
According to BEA documentation, the new approach will improve the deflation methodology for consumer spending on portfolio management and investment advice services to better reflect the timing and quantity of services consumed, improve the deflator used for consumer spending on legal services, and improve the deflator for consumer spending on computer software and accessories to better reflect the composition of products included in this category.
Analysts say the changes in the investment management category were the most significant. Instead of starting with the price and calculating the quantity, BEA analysts will estimate quantity first and then calculate the implied price.
Based on retroactive revisions, it appears the new methodology will slightly reduce price inflation as calculated by the PCE. Between Q4 2020 and the first quarter of this year, the update left the annual PCE at 4 percent. However, core PCE (the primary number the Fed uses in its decision-making process) fell from 3.9 to 3.8 percent. According to the BEA, “These figures reflect the entire annual update, including revised source data and methodology changes. They do not isolate the effect of the methodology changes alone.”
More Reasons for Central Bankers to Love the PCE
As already mentioned, central bankers already love the PCE and consider it a better inflation measure than the CPI.
And we know the CPI understates inflation by design. The powers that be revised the formula in the 1990s to lower inflation readings. Based on the 1970s formula, CPI is around double the official numbers. So, if the BLS used the old formula, we’d be looking at CPI closer to 6 percent. And if they used an honest formula, it would probably be worse than that.
Central bankers will tell you the PCE provides broader coverage of consumer spending, that its chain-weighting formula better captures evolving consumer behavior, that it is consistent with other data sets, including GDP, and that the frequent revisions improve accuracy.
That all sounds good, but there’s a simpler explanation.
The PCE understates price inflation even more than the CPI.
In other words, it consistently tells a better inflation story. And central bankers like nothing better than a sanguine inflation story. If they can convince you inflation isn’t that bad, they can expand the money supply faster without you throwing a fit.
PCE generally runs 0.2 to 0.4 percentage points lower than CPI over longer periods.
With the new adjustment, it will presumably run even lower moving forward.
Both the CPI and PCE formulas create multiple opportunities to skew the numbers lower. Each assumption built into the formula was made up by a government functionary with a bias and agenda.
The PCE’s substitution metrics provide a powerful avenue for number crunchers to skew the data and make price inflation look tamer than it is.
Never forget that government people have a vested interest in making inflation look as tame as possible. In their minds, inflation isn’t a bug. It’s a feature. Their ability to inflate the money supply lays the foundation for big government borrowing and spending. But monetary inflation comes with a nasty side-effect – price inflation. The better they can hide this monetary debasement, the longer they can get away with it without unpleasant political backlash from the citizenry.
Government number-crunchers also want to keep price inflation as low as possible because the PCE is used to “deflate” GDP. If price inflation is lower, it makes real growth look better.
Government data should always be taken with a grain of salt. Never assume that government number-crunchers are unbiased seekers of truth. The numbers may give us some sense of reality. And they are what we have, so we have to use them. However, the government always operates with an underlying propaganda motive. Keep that in mind as you digest the data and the spin.
