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  • Giorgio Tavazza

How the government lies about inflation: The real causes of inflation and the CPI scandal


"By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens."


- John Maynard Keynes



What is inflation?


Let's address the first and most important concept, what is inflation?

As the International Monetary Fund describes it:


“Inflation measures how much more expensive a set of goods and services has become over a certain period, usually a year.”


To make a practical example, if the cost of living rises 10% in a year, inflation is at 10% annually. An inflation rate of 10% would become a problem if nominal wages rise less or don't rise at all, which is the case for most employees and people living on a fixed income.


If wages rise slower than inflation, purchasing power diminishes. Higher poverty rates and social unrest must be expected if the gap between wages and inflation keeps growing and is not reversed promptly.


Inflation can become a real danger to peace and prosperity of a nation. In 1974 The United States President Gerald Ford defined inflation as Public Enemy number one. At that time, inflation was running at 11.04% yearly, and, as you would discover reading the following pages, it was not very far from the real rates of inflation that we are experiencing in 2021 and 2022.


During the 1970s and early 1980s, inflation was eventually tamed by the iron fist intervention of the Chairman of the Federal Reserve, Paul Volcker, who raised interest rates above 20% and drove in 1983 inflation back to 3.21% annually. Although this approach crushed the economy, it avoided a complete loss of confidence in the US dollar, which would have resulted in a bigger and much worse inflationary crisis.


So far, we have understood what inflation is and the real dangers it may pose to society. Now we have to understand what causes it.



What causes inflation?


To better understand the causes of inflation, we can start by reading the famous quote from monetary economist Milton Friedman:


"Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output."


Everybody dreamed at least once in his childhood to own a money printer. To print infinite money and buy everything available, all the toys and candies. The big problem with this childhood dream is that it doesn't consider how money works. In the real world, if the money supply grows too big relative to the size of the economy, prices rise, and purchasing power decreases.


Let's make an absurd example that will make this concept more accessible. Let's say that the US President now decides to send a check to every American for one million dollars. Now, every person in America would become a millionaire. Everybody would rush to buy houses and Ferrari's with their newfound money. But there is one problem: there are the same number of houses and Ferrari as before.

And this would mean that all the buyers would have to bid up the prices of goods and services. More dollars would be trying to buy the same supply, resulting in price inflation.

This phenomenon is called Demand-pull inflation, in which demand for goods and services exceeds the economy's production capacity.


As this unreal example showed, you can print money, but you can't print goods. And this explains why, if the money supply grows too big relative to the size of the economy, prices rise.


Now, it would be unfair to say that inflation is only caused by the growth of the money supply, as it can also be caused by what is defined by "supply shocks" or cost-push inflation.


If, for any reason, the cost of production increases, for example, due to higher energy costs, the overall supply would decrease. Therefore the same demand would be chasing a reduced supply, bidding up prices.


During the Coronavirus crisis of 2020, we saw the perfect inflationary storm. First, the economy got hit hard by lockdowns. Most factories and stores shut down for months, reducing supply. Then, the government increased the money supply drastically, lowered interest rates to zero, and sent checks directly to the people. These policies created a boom in demand as people had more money and could borrow cheaply.


What was the result? A booming demand was chasing fewer supplies, which led to high inflation.


As we have seen before, the money supply must be elastic to ensure price stability. A growing economy should have an increasing money supply. A shrinking economy should have a shrinking money supply.


If price stability were the real goal of the Fed, in 2020, the right monetary policy would have been contracting money supply, not the opposite.



Is the government telling the truth about inflation?


If I told you that the average price to buy a new car in 1997 was the same as in 2017 would you think I am crazy?


Source: Fred.stlouisfed.org



According to the official US government numbers, I wouldn't be crazy. I would be correct. And this is thanks to the Consumer Price Index:


The Consumer Price Index (CPI) is the most important measure that the government uses to gauge inflation and the cost of living. It measures a weighted average of the prices of a basket of goods and services.


The CPI should supposedly reflect the changes in the cost of living. However, due to a series of changes made in the calculation process of the CPI, many believe it distorts reality to reflect a lower amount of inflation.


You could see an example of this distortion from the average price of a new car in 1997 and 2017. According to the CPI, the average car costs the same. This distorted data is due to the government's adjustments.

If a good or service (a car in this example) costs more and has improved quality and features, the government would consider that the cost didn't increase since consumers are getting higher quality for a higher price.


Thanks to these adjustments, since now cars have better navigation systems, better safety features, and much more, the CPI doesn't account for most of the average price increase of a new vehicle compared to 1997.


This "improvement" adjustment is only one of the many new controversial adjustments the government introduced during the last 50 years.


One of the most controversial adjustments is the "consumer behavior" adjustment. If, for example, the price of beef increases substantially and consumers change behavior by purchasing less beef and more eggs or chicken, then the government wouldn't account for the beef price increase in the CPI as the consumer found a valid substitute.


Another adjustment is the Owners' Equivalent Rent (OER). In 1983 the Bureau of Labor Statistics (BLS) changed the calculation of shelter's costs. Before 1983

home purchases were considered a consumption expenditure, and therefore, house prices were part of the CPI. Before 1983 a change in the median home price would have seen an increase reflected in the CPI.


Instead, thanks to the adoption of Owners' Equivalent Rent (OER), a house is now considered a capital asset or investment. Shelter cost is now calculated by monthly surveying consumers who own a primary residence. The survey asks how much money a property owner would have to pay in rent to be equivalent to their cost of ownership.


You are right if you think OER is confusing and if you think it is unfair to disregard house prices and mortgage costs while calculating shelter costs. Data suggest that the BLS introduced OER in 1983 to manipulate CPI to appear lower.





Why is it crucial for the government to have a low CPI?


It is now clear that the government is doing its best to keep the CPI as low as possible, adjusting every variable imaginable. But why so much effort?


The CPI has great importance concerning GDP (Gross Domestic Product). The CPI is used to calculate real GDP by deflating some of the components of the nominal GDP to account for inflation. Suppose the nominal GDP growth is 5% while inflation is running at 10%. In that case, the economy is weaker than it seems, as the real GDP growth accounting for inflation would be negative instead of positive.


By having a lower CPI, the government can appear to have a more robust economy.


The CPI is also linked to government spending. Many government expenses such as Social Security and Treasury Inflation Protected Securities (TIPS) use the official CPI number to adjust for inflation. Therefore a lower CPI also means lower government expenses.


Last but not least, the CPI directly affects the behavior of consumers. If CPI gets high enough, people begin to get concerned about inflation. They start to expect more inflation and therefore act differently. Consumers would begin hoarding durable consumer goods expecting to be paying more for them in the future. This behavior would create more demand which would generate higher inflation. At the same time, people would start asking for raises in wages, leading to increased production costs and, therefore, more inflation.


The last thing the government wants is to create an inflationary panic in the consumers, as the panic itself would create more and more inflation.


I hope you have now realized that the government has many incentives to manipulate the CPI numbers. Therefore, it is advised to look at other metrics to gauge accurate inflation rates.


Looking directly at the price increases of goods and services will give you a clearer image of the actual inflation rates. It's a simple exercise that would require asking yourself: How much was this good or service costing me last year compared to now?


If you look at cars, meat, coffee, oil, rent, and housing, you will find double-digit price increases.




The devastating effect of inflation on your purchasing power:


Most people understand that with 10% annual inflation, they lose 10% of purchasing power each year. This rate means that a hypothetical $100,000 today would be worth $90,000 one year from now.


To put it simpler, if today, with $100,000, you could buy 100 iPhones, your $100,000 would allow you to buy only 90 iPhones in one year.

This concept is pretty easy, and although nobody likes a loss of purchasing power of 10%, for many is not viewed as the end of the world.


What most people don't see is that inflation compounds annually. If something that costs $1,000 has a 10% inflation, it will cost nearly triple the amount after ten years. (after ten years of compounding at 10% annually, it would cost $2,593.74 to purchase the same item)


The problem with exponential growth is that it is exponential. After 20 years, the same item would be priced at $6,727.50, almost seven times the initial price. In other words, your money would have lost more than 85% of its original purchasing power in just 20 years. And as we have seen, the problem keeps getting bigger with time. In 25 years, the item would be priced at $10,834.71. And in 30 years, the same item that once cost $1,000 would cost $17,449.40, which means that after 30 years, you would have lost almost 95% of your total purchasing power.


Please let these numbers sink in for a second.


If you don't find a way to fight inflation, you will lose most of your hard-earned savings during your lifetime. And if you think it is not possible or that these inflation rates are too high to be real, let's look at the past.



Source: Finbold.com



The US dollar has lost 85% of its value in the last 50 years. From 1971 to 2021, the dollar lost 85% of its purchasing power, and this is using the official CPI data, which I hope by now you understand should be much higher.


Inflation compounds annually, and as Albert Einstein said:


"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't... pays it."


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