What Should the "Basket of Goods" Really Be?

[moda0306]

I was thinking about this nebulous thing we argue about... inflation... and I was thinking about what appears to be the case today... whether because of monetary policy or commodity shortages, some prices (commodities) are rising while others (wages, housing, consumer electronics) are falling.

I'm assuming that the CPI is a basket of goods that contains everywhere from food to electronics, but for illustration's sake, let's assume that those are the ONLY two things that make up CPI to represent the two ends of the spectrum of the effect I think we're seeing... Food, and I-Pods.

In a prosperous economy, the "average" consumer (based on whatever statistics the BLS uses) spends 20% of their budget on food, and 80% on i-pods.  They then proceed to use this as a gauge for CPI.

Now, a huge recession hits.  People quit buying i-pods, but buy just as much food.  This changes the ratio from 20/80 to 35/65.  But the masterminds at the BLS haven't had time to see this adjustment, or think it's inappropriate to make that adjustment... so they keep the ratio the same of what these people spend their money on.

Now Nobel Economist Kaul Prugman gets on the news saying, "Look, our CPI is flat.... even moreso, we CAN'T use food as an indicator, so let's remove that 20% from the calculation... it's a commodity and it's too volatile... let's wait for the price of that food to actually affect the cost of the i-pod, and use the i-pod as an indicator as to whether we're experiencing inflation."

Meanwhile, somebody else might say that because Americans are now consuming a "different basket" of goods, or maybe also because they SHOULDN'T have been consuming so many i-pods to begin with based on their budgets, that maybe a completely different basket should be used.

I'm curious to know (and I'm sure the information is available) how they form this "basket" in terms of needs vs wants.  I can understand wanting to pull food/fuel out for volatility reasons, but it seems almost asinine to assume that "inflation isn't here until expensive necessities make unnecessary consumer goods more expensive than they were last month."

Anybody with more knowledge on how CPI is calculated, I'd love to hear your input.

[KevinW]

IMO the difficulty in defining inflation in a meaningful way highlights why central planning is so difficult.

Any operational definition of "want" and "need" is going to have corner cases that don't fit right.  Shelter is a need, but should the marginal cost of private pools, guest rooms, remodelled kitchens, and so on, be averaged in to "shelter?"  Most spending on bicycles is on high end race bikes, but I use a bicycle as basic transportation; are bicycles "wants" or "needs?"  Over the last 30 years personal computers have arguably become a "need," and transformed past "needs" into "wants" (newspapers, reference books, wrist watches, stationery, etc.).  How is a committee supposed to keep up with all of that?

One idea might be to look at spending among households near the poverty line.  They're forced to put their money where their mouth is regarding "needs" vs. "wants."  Perhaps whatever they buy is a "need" and everything else is a "want."

[moda0306]

Kevin,

Great stuff.

Assuming most poor people are wise-spenders (most may not be), then their inflation is very much made up of food, fuel and rent, two of which have seen pretty heavy inflation the last several years, but also tend to be very volatile and could be based on commodity scarcity, not just QEII...

Your right... how do the "planners" get around all this...

[MediumTex]

One idea might be to look at spending among households near the poverty line.  They're forced to put their money where their mouth is regarding "needs" vs. "wants."  Perhaps whatever they buy is a "need" and everything else is a "want."

I have seen data indicating that this group spends a disproportionate amount of their income on music and other entertainment (CDs, downloads, etc.), tobacco and lottery tickets, which might explain (at least in some cases) why they are near the poverty line.

Maybe they wouldn't be a good group to benchmark against.

[moda0306]

One idea might be to look at spending among households near the poverty line.  They're forced to put their money where their mouth is regarding "needs" vs. "wants."  Perhaps whatever they buy is a "need" and everything else is a "want."

I have seen data indicating that this group spends a disproportionate amount of their income on music and other entertainment (CDs, downloads, etc.), tobacco and lottery tickets, which might explain (at least in some cases) why they are near the poverty line.

Maybe they wouldn't be a good group to benchmark against.

Ha... I was thinking the same thing... thought I'd keep to the "theoretical" food and fuel arguments.

[SteveGo]

One idea might be to look at spending among households near the poverty line.  They're forced to put their money where their mouth is regarding "needs" vs. "wants."  Perhaps whatever they buy is a "need" and everything else is a "want."

I have seen data indicating that this group spends a disproportionate amount of their income on music and other entertainment (CDs, downloads, etc.), tobacco and lottery tickets, which might explain (at least in some cases) why they are near the poverty line.

Maybe they wouldn't be a good group to benchmark against.

And that data is what?

[KevinW]

It's true that, due to selection bias, people near the poverty line will on average be less financially literate.  There's also the catch-22 that they're priced out of many of the resources and experiences that could improve that.  So treating them, on aggregate, as rational agents makes a dangerous assumption.

That being said, it seems impossible to quantify what a "cost of living" is without making value judgements about what other people should or shouldn't be spending money on.

[moda0306]

That being said, it seems impossible to quantify what a "cost of living" is without making value judgements about what other people should or shouldn't be spending money on.

Exactly... but since we're so good at making value judgements, think of consts of these items compared to 10 years ago:

Food: Costs more
Rent: Meh
Medicine: Costs more
Education: Costs more
Fuel for transportation and warmth: Costs more

Most of these are considerably more expensive today than 10 years ago.

This isn't all due to monetary policy, and there are poor people out there that are irresponsible... but seriously it really sucks to be on the bottom of society if these are your main expenses.

[Storm]

I always thought it was BS that housing costs weren't in there.  Rent was in it, but mortgages were explicitly excluded.

If mortgages and housing costs were in the CPI, we would have seen the truly double-digit inflation that occurred throughout the 2000s decade.  It would also do a lot to explain what happened to gold during the same time period.

[moda0306]

The thing is, those that bought in 1997 didn't see that inflation... it was just home equity that could have chosen to use.

Those that bought in 2005 aren't seeing the deflation in their mortgage cost at this point... high principal, high (6%+) interest, and maybe some PMI to boot.

And again, those who've bought within the last year, while maybe seeing some loss in equity, are in a much better position than others.

But your point is totally valid... it's just interesting to see that some have paid for the housing crisis MUCH more than others, and I think most of this comes down to just dumb luck for most people.

For people in my age group, this is especially interesting to see, because some of the most responsible people my age bought at a younger age since they were more financially stable sooner... this was maybe 2007 or so.

The friends I know that are looking now are the "late to the party" types that are just getting their lives figured out and its something to see them paying a much lower rate on a cheaper home than my more responsible friends.

This is all averages of course.

[MediumTex]

One idea might be to look at spending among households near the poverty line.  They're forced to put their money where their mouth is regarding "needs" vs. "wants."  Perhaps whatever they buy is a "need" and everything else is a "want."

I have seen data indicating that this group spends a disproportionate amount of their income on music and other entertainment (CDs, downloads, etc.), tobacco and lottery tickets, which might explain (at least in some cases) why they are near the poverty line.

Maybe they wouldn't be a good group to benchmark against.

And that data is what?

Here is a short article referring to a study showing how much income poor people spend on lottery tickets:

http://www.essence.com/2010/06/02/study ... ney-on-lo/

Here is an overview of research showing that in most societies poor people tend to use tobacco more than other groups and spend a greater proportion of their income on it:

http://www.qsep.com/modules.php?name=as ... cle&aid=38

Here is a link to a study of how poor people around the world tend to spend money:

http://www.ncbi.nlm.nih.gov/pmc/articles/PMC2638067/

The paper touches on the tendency of very poor people in some Third World nations to spend a lot of money on "festivals" (it also touches on the tobacco issue as well), while poor people in the U.S. tend to spend about 5% of their income on movies and other forms of entertainment, and how the spending patterns may be analogous but be affected by the availability of different entertainment outlets.

An excerpt:

Yet among the nonfood items that the poor spend significant amounts of money on, alcohol and tobacco show up prominently. The extremely poor in rural areas spent 4.1 percent of their budget on tobacco and alcohol in Papua New Guinea; 5.0 percent in Udaipur, India; 6.0 percent in Indonesia; and 8.1 percent in Mexico. However, in Guatemala, Nicaragua, and Peru, no more than 1 percent of the budget gets spent on these goods (possibly because the poor in these countries prefer other intoxicants).

Perhaps more surprisingly, spending on festivals is an important part of the budget for many extremely poor households. In Udaipur, over the course of the previous year, more than 99 percent of the extremely poor households spent money on a wedding, a funeral, or a religious festival. The median household spent 10 percent of its annual budget on festivals. In South Africa, 90 percent of the households living under $1 per day spent money on festivals. In Pakistan, Indonesia, and Cote d’Ivoire, more than 50 percent did likewise. Only in some Latin American countries in our sample—Panama, Guatemala, Nicaragua—are festivals not a notable part of the yearly expenditure for a significant fraction of the households. However, in the LSMS surveys, unlike the Udaipur survey, people are not asked to account separately for the food that they bought because of a festival. It is therefore probably no accident that the Udaipur spending on festivals is the highest across the surveys. The LSMS numbers would probably have been higher if data on food spending because of festivals had been directly collected in those surveys.

On the other hand, the under-$1-per-day households spend very little on forms of entertainment common in high-income countries such as movies, theater, or video shows. In all 13 countries in our sample, in the month preceding the survey the average extremely poor household spent less than 1 percent on any of these forms of entertainment. The comparable number for the United States is 5 percent. We can only speculate about the roots of this difference. Has the importance given to festivals and other indigenous forms of entertainment crowded out movie-going? Or is the answer as simple as a lack of access to movie theaters?

***

The poor do see themselves as having a significant amount of choice, but they choose not to exercise that choice in the direction of spending more on food. The typical poor household in Udaipur could spend up to 30 percent more on food than it actually does, just based on what it spends on alcohol, tobacco, and festivals.

[Storm]

I'm always fascinated by the correlation vs. causation argument:  Are poor people poor because they spend a large percentage of their money on worthless things (alcohol, tobacco, lottery tickets), or is this merely a sign that they are poor at managing money?

I'd generally go with the latter.  Poor people are less educated about how to properly manage money and this makes them a higher risk for poorly managing their finances, which in turn keeps them poor.

I mean, how many people do you see at your average grocery store or minimum wage job taking smoke breaks out behind the store?  With cigarettes costing $10 a pack in some states now, and minimum wage at $7.25, you could literally be smoking $1 of your salary every hour if you just smoke 2 cigs.

[moda0306]

Storm,

I'm no raging conservative, but I think it's more than just "education" in some ways.  I could go up to a poor guy and tell him 100 different ways how his spending habits could be improved to improve his life, and he probably would light up another cigarette and tell me to buzz off.

While I think we've utterly failed in financial education, I'll be the first to admit that simply telling a disinterested person how to manage money and improve their life won't necessarily help.

The sad thing is, they're probably in the rut they're in not because at age 5 they decided to suck at life, but at age 5, instead of teaching them how to read, their parents had them sitting in front of the tv while they drank out on the porch, and yelled at them to shut-up every time they got curious and asked a question about how the world works.

[Storm]

I think you're right, moda, it's more than that, but we seem to fail in this country at teaching kids basic financial literacy.  It should be taught in school, along with math, reading, science, and history.  Not to get too off topic here, but I found this fascinating:

http://www.forbes.com/2010/01/12/cfpa-f ... ooley.html

The level of financial knowledge among U.S. households is shockingly low, and that fact is at odds with the trend of shifting risk management to households.

How bad is it? Two economists, Annamaria Lusardi and Olivia Mitchell, have been studying financial literacy and the effectiveness of efforts to promote it for many years. The results are not at all encouraging. To take just a few of their examples, they asked the following questions of a representative sample of Americans over the age of fifty:

1. Suppose you had $100 in a savings account and the interest rate was 2% per year. After five years how much do you think you would have in the account if you left the money to grow: more than $102, exactly $102, less than $102?

2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year would you be able to buy more than, exactly the same as or less than today with the money in this account?

3. Do you think that the following statement is true or false? "Buying a single company stock usually provides a safer return than a stock mutual fund."

Only 50% of respondents were able to answer the first two questions correctly and less than a third were able to answer all three. In a related study less than 18% of people surveyed were able to answer a simple two-period compound interest problem. This is pretty discouraging. Not surprisingly the extent of financial illiteracy differs with education, gender, race and age. Most efforts to improve financial literacy are not effective.

[moda0306]

Have to laugh to keep from crying.

I agree... I really think financial education is an absolute must.

[KevinW]

It should be taught in school, along with math, reading, science, and history.

+1.  That's what "home economics" ought to cover IMO.

[gizmo_rat]

That being said, it seems impossible to quantify what a "cost of living" is without making value judgements about what other people should or shouldn't be spending money on.

Good call, I know in other circumstances I'd be consuming a lot of tobacco, booze, lottery tickets and festivals just to keep myself going.

By definition discretionary income is spent on what makes you feel good right now, whatever that might be.

Doesn't help measure inflation though...

[Wonk]

How about MIT's billion prices project?

http://bpp.mit.edu/usa/

Seems to be a much larger sampling and perhaps more representative of overall price levels.

[HB Reader]

I always thought it was BS that housing costs weren't in there.  Rent was in it, but mortgages were explicitly excluded.

If mortgages and housing costs were in the CPI, we would have seen the truly double-digit inflation that occurred throughout the 2000s decade. 

I hear this sentiment a lot, but I don't believe the issue is so clear.

The cost of housing in the CPI was replaced by rental equivalence in 1983.  As strange as it may sound to people today, I clearly remember many outraged pundits in the media and on opinion pages and political talk shows screaming for this change because they claimed the government was deliberately OVERSTATING the CPI in order to "buy" the votes of social security recepients and federal and military personnel whose pensions were linked to the index. 

The reason given by the BLS for the 1983 change actually was that housing had come to represent both a consumer item and an investment item for many people and the CPI was not supposed to include investment purchases.  Most other countries also use rental equivalence for this same reason.

A 2008 article entitled "Common Misconceptions about the CPI: Qs & As" on the BLS website states the following: "when it was first introduced, rental equivalence actually increased the rate of change of the CPI shelter index, and in the long run there is no evidence that the CPI method yields lower inflation rates than some other alternatives. For example, according to the National Association of Realtors, between 1983 and 2007 the monthly principal and interest payment required to purchase a median-priced existing home in the United States rose by 79 percent, much less than the rental equivalence increase of 140 percent over that same period."  (I suspect that is because of steadily falling interest rates over the 1983-2007 period.)

You can choose to believe the BLS or not, but I know for a fact their numbers are not politically massaged they way many people seem to assume.  My wife worked at the BLS as an economist for many years.
 
I think the bigger problem here is the public misunderstanding of what the CPI actually represents.  It is simply a price index of a basket of goods.  The BLS has never claimed it to be a complete "cost of living" index.  The information is nonetheless unquestioningly presented that way by the media and political figures and pundits of various stripes depending on their agendas.  There also appears to be considerable public confusion about the difference between the regular CPI (which includes food and energy and is the index with which most legislated uses of the CPI are linked) and the so-called "core CPI" (which excludes food and energy and is used by economists and the Federal Reserve for monetary policy purposes).

[moda0306]

I think a lot of people get angry that the fed uses core CPI, and I can understand that anger, but assuming we do need to have an inflation indicator help us with monetary policy (I understand some would like to see no "monetary policy" other than a gold standard, but that's a separate argument), it really does make sense to "tame" some of the more volatile, commodity-based portions of it so you don't have "rampant inflation" one month but have a "deflationary disaster" another.

That said, if the fed increases the money supply during a recession, the money won't necessarily go into the i-pods... the very nature of a recession has people concentrating a greater total value of their income on necessities... food and fuel are a couple of these... so is the increase in price we're seeing where all the inflation is manifesting itself simply because a change in demand for non-essentials as a % of the total basket.

[Storm]

I always thought it was BS that housing costs weren't in there.  Rent was in it, but mortgages were explicitly excluded.

If mortgages and housing costs were in the CPI, we would have seen the truly double-digit inflation that occurred throughout the 2000s decade. 

I hear this sentiment a lot, but I don't believe the issue is so clear.

The cost of housing in the CPI was replaced by rental equivalence in 1983.  As strange as it may sound to people today, I clearly remember many outraged pundits in the media and on opinion pages and political talk shows screaming for this change because they claimed the government was deliberately OVERSTATING the CPI in order to "buy" the votes of social security recepients and federal and military personnel whose pensions were linked to the index. 

The reason given by the BLS for the 1983 change actually was that housing had come to represent both a consumer item and an investment item for many people and the CPI was not supposed to include investment purchases.  Most other countries also use rental equivalence for this same reason.

A 2008 article entitled "Common Misconceptions about the CPI: Qs & As" on the BLS website states the following: "when it was first introduced, rental equivalence actually increased the rate of change of the CPI shelter index, and in the long run there is no evidence that the CPI method yields lower inflation rates than some other alternatives. For example, according to the National Association of Realtors, between 1983 and 2007 the monthly principal and interest payment required to purchase a median-priced existing home in the United States rose by 79 percent, much less than the rental equivalence increase of 140 percent over that same period."  (I suspect that is because of steadily falling interest rates over the 1983-2007 period.)

You can choose to believe the BLS or not, but I know for a fact their numbers are not politically massaged they way many people seem to assume.  My wife worked at the BLS as an economist for many years.
 
I think the bigger problem here is the public misunderstanding of what the CPI actually represents.  It is simply a price index of a basket of goods.  The BLS has never claimed it to be a complete "cost of living" index.  The information is nonetheless unquestioningly presented that way by the media and political figures and pundits of various stripes depending on their agendas.  There also appears to be considerable public confusion about the difference between the regular CPI (which includes food and energy and is the index with which most legislated uses of the CPI are linked) and the so-called "core CPI" (which excludes food and energy and is used by economists and the Federal Reserve for monetary policy purposes).

What a great post, HB Reader.  I suspect that the NAR intentionally cherry-picked the date range to get the result they wanted.  By going back to 1983, when interest rates were extremely high, and using mortgage payments instead of asset prices, they can get the result that shows buying a house is "cheaper" than renting.  If they set the date range to 1997-2007 the result would be dramatically different.  You have some very good points, that the investment characteristic of home ownership makes it difficult to factor into the CPI, but I would argue that the fact that people look at a home as an investment in the first place is a symptom of a greater societal problem.  Houses have always been consumption items, and it is only in the last 20 years or so when Ben Bernanke started the easy money spigot that people started looking at them as speculative investments.

But, the NAR is the #3 lobbyist group in the country, and all of those dollars are going to buy some policy decisions, especially as it relates to inflation.

I think a more pure approach to asset price inflation would be to look at property values, commodities, and even gold combined together into an equation that gives you the rate of inflation.

[MarySB]

Simple answer:

Basic Needs as in first grade curriculum: food, clothing, and shelter.

See, economics IS taught in schools, in the social studies curriculum

[MarySB]

Personally, I might add health care as well. If your health needs are not addressed, you won't live long enough to care, anyway IMHO!

[HB Reader]

I suspect that the NAR intentionally cherry-picked the date range to get the result they wanted.  By going back to 1983, when interest rates were extremely high, and using mortgage payments instead of asset prices, they can get the result that shows buying a house is "cheaper" than renting.  If they set the date range to 1997-2007 the result would be dramatically different.  You have some very good points, that the investment characteristic of home ownership makes it difficult to factor into the CPI, but I would argue that the fact that people look at a home as an investment in the first place is a symptom of a greater societal problem.  Houses have always been consumption items, and it is only in the last 20 years or so when Ben Bernanke started the easy money spigot that people started looking at them as speculative investments.

But, the NAR is the #3 lobbyist group in the country, and all of those dollars are going to buy some policy decisions, especially as it relates to inflation.

I think a more pure approach to asset price inflation would be to look at property values, commodities, and even gold combined together into an equation that gives you the rate of inflation.

I guess I didn't make my point clearly.   

I didn't mean to endorse or reject the idea that housing should be viewed as an investment.  I certainly don't consider it an investment.  But I don't think using rental equivalence makes the BLS methodology flawed.  Most of the rest of the world doesn't either.  Most people don't go out and buy a house or obtain a new mortgage each year, so why is it any more logical to use housing and mortgage prices than rental prices to determine the cost of shelter?  I seriously doubt this BLS methodology change in 1983 or related policy decisions were swayed by NAR dollars.

I don't doubt that that the NAR chose a favorable multi-year period (like any proponent) to make their comparison -- although it is logical in a 2008 paper to cover the 1983 to 2007 period since that is the entire time frame that the methodology in question had been employed.   Using 1997 to 2007 may or may not yield a dramatically different result.  Presumably the years 2007 to 2010 will also produce different results.  As I pointed out, prior to 1983 many people thought using housing and mortgage prices distorted the index in an opposite direction.  I don't think the differring results have much bearing on the soundness of the methodology. 

The point is that the CPI is an index of prices paid by consumers for a representative basket of goods and services.  Nothing more, nothing less.  It is not and never has been a complete "cost of living" or an "asset price" index.  Most people blithely make that assumption because that is how it is presented to them by a lazy media or pundits who are out to prove some point.  On their website, the BLS points out there are many different indexes that measure inflation and the "best" one in any given circumstance depends on the intended use of the data.  There never will be an ideal basket of goods or one comprehensive inflation index. 

[Storm]

I guess I didn't make my point clearly.   

I didn't mean to endorse or reject the idea that housing should be viewed as an investment.  I certainly don't consider it an investment.  But I don't think using rental equivalence makes the BLS methodology flawed.  Most of the rest of the world doesn't either.  Most people don't go out and buy a house or obtain a new mortgage each year, so why is it any more logical to use housing and mortgage prices than rental prices to determine the cost of shelter?  I seriously doubt this BLS methodology change in 1983 or related policy decisions were swayed by NAR dollars.

I don't doubt that that the NAR chose a favorable multi-year period (like any proponent) to make their comparison -- although it is logical in a 2008 paper to cover the 1983 to 2007 period since that is the entire time frame that the methodology in question had been employed.   Using 1997 to 2007 may or may not yield a dramatically different result.  Presumably the years 2007 to 2010 will also produce different results.  As I pointed out, prior to 1983 many people thought using housing and mortgage prices distorted the index in an opposite direction.  I don't think the differring results have much bearing on the soundness of the methodology. 

The point is that the CPI is an index of prices paid by consumers for a representative basket of goods and services.  Nothing more, nothing less.  It is not and never has been a complete "cost of living" or an "asset price" index.  Most people blithely make that assumption because that is how it is presented to them by a lazy media or pundits who are out to prove some point.  On their website, the BLS points out there are many different indexes that measure inflation and the "best" one in any given circumstance depends on the intended use of the data.  There never will be an ideal basket of goods or one comprehensive inflation index. 

HB Reader, I think you made yourself perfectly clear, I just respectfully disagree.  In a nation where 65% of families are homeowners (formerly 67%), any inflation statistic that ignores the increasing price of housing seems fundamentally flawed.  I realize that rent equivalence may be acceptable to the rest of the world, but in most of Europe and Asia a large percentage of people rent, so it seems perfectly natural to use that comparison.  In the US, where home ownership is looked as as the "American Dream," and huge tax and government incentives exist to encourage home ownership, I think it is disingenuous to remove house pricing from total inflation statistics.

I see that you're saying CPI measurements don't really reflect the true cost of living, but doesn't that seem wrong to you?  When pension and retirement benefits are based solely on CPI measurements that fail to give any weighting whatsoever to the largest expense that most Americans have each month, doesn't that seem wrong?  Housing has a deep and profound affect on each person's bottom line, as it is most likely the largest expense we will have throughout our lives.  To discount this completely and turn us into a nation of renters just seems wrong to me.