The Boskins Commission has recently argued that the measure of the CPI in the US may well over overstate price inflation by up to 1.1% per year - a figure that has come under criticism for being too high. This is due to the failings of the index to account for substitutions to cheaper alternatives and to account for quality improvements. Consequently, allowing for some room for downside risk, the Federal Reserve is unlikely to consider it desirable for inflation to fall below 2%.. www.g7.utoronto.ca/evaluations/1997denver/compliance/us/usamac.htm

Have you ever wondered how come US inflation can remain so low when we know that prices of so many things have been going up year after year at a rate quite a bit higher than the official inflation rate?

The answer is easy – just read the first paragraph again. Focus on just one thing: Inflation is overstated by up to 1,1% a year because the index does not account for substitutions and quality improvements.

Let us take a look at what this means.

Substitutions first and we will use some quite ridiculous examples to get the point across. Do not make the mistake of laughing at the simple examples – rather start crying because of what these mechanism do to the people who receive Social Security payouts that are linked to inflation, and to others in a similar situation.

Consider four things as they stand at the beginning of January:

The price of an apple = $1.00

The price of a pear = $1,00

Inflation index = 100

Social Security payout for pensioner X = $1000

At the end of January the price of apples have risen to $1,10, while pears are still $1,00. Calculating the inflation index for January, the Law of Substitution for Cheaper Products says that people would have stopped buying apples and bought pears instead. Since the price of pears are unchanged, there is no change in the inflation index. So, at the end of January we have:

The price of an apple = $1.10

The price of a pear = $1,00

Inflation index = 100

Social Security payout for pensioner X = $1000

The increased demand for pears in January worked through the system so that at the end of February the price of pears has risen to $1,25. However, it seems that since there was a surplus of apples left over from January, the price of apples did not change at all. Which, of course, means that when the inflation index for February is calculated, the Law of Substitution for Cheaper Products uses the price for apples as the basis for the calculation.

This means that at the end of February we have:

The price of an apple = $1.10

The price of a pear = $1,25

Inflation index = 100

Social Security payout for pensioner X = $1000

Taking this reasoning trough to its conclusion at the end of the year, we find that in December we have

The price of an apple = $1.40

The price of a pear = $1,40

Inflation index = 100

Social Security payout for pensioner X = $1000

There was no inflation!

What the buyer of apples and pears think they observe is pure illusion – the fruit only appear to be more expensive, because the Law of Substitution for Cheaper Products says inflation was zero.

Of course, the pensioner who still only receives a $1000 payout from Social Security has by now stopped buying apples and pears and is eating bananas instead.

What about quality improvements?

Well, at the beginning of the year bananas cost $1.00 a bunch. By December they were up to $1.10 (soon to rise steeper as more pensioners on Social Security make the switch from apples and pears). Luckily for the calculation of the inflation index, the importation of bananas has switched from country A to country B and now the bananas have 10% fewer black spots on the skin than before.

This fact is taken into regard when the inflation index is calculated and the result is that the apparent price of $1.10 at the end of December is really still only $1.00, because of the improvement in quality. In this best of all possible worlds the inflation index remains at 100, to show that there is no inflation – a fact that, since inflation is such a great big bogey bear for central bankers, makes them very happy.

Of course, they are not among the pensioners on a Social Security pension who very soon will not be able to purchase any fruit at all. So who cares.

OK. The example is ridiculous. But the principle stands.

Other ramifications

There are, of course, a great many other ramifications of this system.

Consider just one of the side effects of all this hedonic manipulation.

Assume the economy consists of only two products – apples and pears. There are 1000 households and they each consume 5 units of fruit each month. We can calculate a monthly GDP for this economy using, for simplicity sake, the starting price for January for January’s GDP and later the ending price for the calculation for December.

The year begins with a GDP of 1000 x 5 x $1.00 = $5000.

The year then ends with a GDP 1000 x 5 x $1.40 = $7000.

Gee golly! Great guns! What fantastic growth! A massive 40% growth in one year and that with not a whisker of a sign of any inflation. This achievement surely speak wonders for the wisdom and ability of the central bankers. They deserve not only a pat on the shoulder, but a very good bonus too, for a job well done.

A really good bonus, too, so that they can continue to afford buying apples and pears and not have to switch to bananas like the pensioners.

Again, laugh at the example if you will.

But then sit back and really think hard for a while. You will realise that this is actually happening out there. It is not a fairy tale. It is real life.