CPI index | Inflation | Finance & Capital Markets | Khan Academy

Everyone's talking about
inflation and deflation these days, including myself, and
that's because it's important. And in order to really have an
informed view on it, I think it's important to actually
look at how inflation is defined. And right here, I actually
took a screenshot from my Bloomberg terminal, of the
basket of goods that makes up the Consumer Price Index. The index that sets everything
from the coupons on Treasury inflation-protected securities–
this is the index that dictates what Social
Security payments are, how fast they're going to grow. I'm sure a bunch of union
agreements and pension agreements are dependant
on the CPI. So this is the underlying basket
of goods that really tells us what inflation is. At a first level, it's just fun
to look at, because you can compare your own household
to what the government thinks is a typical household.

For example, the government
says that the typical household spends 15.7% of their
disposable income on– and that's essentially the
income that you take home after paying taxes–
that they spend 15.7% on food and beverages. That seems reasonable. What's even more interesting
is that they break it down. They get very granular. They try to figure out how much
do you spend on eggs, and fish, and poultry, and
bakery products. And that's good because, let's
say, everything else stays constant, but the price of eggs
goes through the roof because the Atkins diet
becomes popular again.

Then you can actually make an
informed decision as to why inflation is going up or whether
inflation will go up going forward. So that's just interesting
to look at. If you look at the
major categories. They have food and beverages,
housing– And I'm going to come back to housing because
this is, in general, just a very interesting area to focus
on, because it makes such a big portion of the CPI. And it's been such a big
portion of the economic picture, especially
the last 10 years.

And obviously, it's become a big
problem, has become a big factor, in terms of what's
causing the financial crisis right now. But housing is about 43%
of disposable income. Apparel: 3%. Transportation: 15%. This includes things like
new vehicles, 4%, used cars and trucks. And I think the way they
calculate this is, they say, what percentage of Americans
are driving new vehicles versus used vehicles? And they put fuel in here. A lot of people, when I have
this inflation-deflation argument, they make this
argument that China and India are going to continue growing. And because of that, commodities
like oil and fuel will continue to increase. Although people were making
that argument more last summer, but even now people
are making that argument. But in a developed country, you
see that motor fuel, even though it hits your pocketbook
on the margin, it isn't that big a part of your total

Especially when you compare
it to things like housing. And if you keep going down,
medical care: 6%. And then recreation. They break it down and you
could look this up. I think the Bureau Of Labor
Statistics has this broken down as well, although it was
much easier to get it on the Bloomberg terminal. Education: on average, 3%. Obviously, if you're sending
your kids to college that's a much higher number, but, on
average, if you take the average household. And finally, other goods
and services: tobacco, et cetera, et cetera.

So that one is just interesting
to look at. So whenever you have a
discussion on the things that may or may not drive inflation,
it's important to weigh them by these weightings
that the CPI gives them, to figure out what the actual
impact on how we measure inflation really will be. With that said, if you think
about it, really the biggest portion of this is the
housing piece. I think that's fair. Housing is a large percentage
of most people's disposable income, especially in
a Western society.

You can imagine, if you live in
a Third World country, and you're barely getting by, food
might be a huge part of your expenditure, maybe rivaling
housing if you've just kind of built a house someplace. But in a developed society,
housing is a huge percentage of it. And I want to focus on one
thing, and a lot of people have talked about this. And actually Mish once again,
from Global Economic Analysis, he really encouraged me
to highlight this. So within housing, obviously
some people rent, some people buy. And so they give a 6% weighting
of the whole basket to rent, and then they give a
roughly 24%, 25% weighting to something that they call,
owners' equivalent of rent of primary residence. So this is essentially their
attempt to measure how much it costs to live for people
who own houses. What's interesting, and you
probably have caught onto it, is they use the words: owners'
equivalent rent. So what they do, and this is the
current methodology, they don't say, how much
is your mortgage? They don't say, how much does
it cost you to buy the house and amortize it over the
reasonable life of the house? They actually just say, how
much would it cost to rent that house? And they've kept waffling back
and forth between– sometimes they just look for equivalent
houses, and they say, well, how much would that
cost to rent? At one point they were actually
surveying people and they would ask them, how
much would it cost to rent your house? Which is probably even
a worse number.

But the bottom line is, they're
not factoring in actual mortgages. And you can even see it
on the weighting. Right when I looked at these
numbers, I was like, well, roughly 66% of people
own houses. How come this number isn't
66% relative to this number, right? It's closer to 80%. I was like, oh, I know that's
fair because more people actually live in homes. You could say that 66% of
overall households own, but, in general, homes are bigger,
there might be more people in it.

So you could either think of it
on a person basis or maybe on a square footage basis. It makes a little bit more sense
to weight houses higher. But what's interesting here,
is that this number, especially if you add these
two, housing in general is about 30% of disposable
income. And traditionally that was the
rule that a bank would use to decide whether you can
afford a house. It shouldn't be more than a
third of your disposal income, or at least a mortgage
payment shouldn't be more than a third.

We know, especially over this
last real estate bubble, that's become a much, much
larger percentage of people's actual disposal income. So you wonder, why is this
weighting only 30% of disposable income? Well, that's because they use
owners' equivalent rent. They didn't actually
say what people's mortgage payments are. So even though mortgage payments
might be going through the roof, even though
the price of a house might be going through the roof, it does
not get reflected in the CPI number as of
the early `80s. This is straight from
the Bureau Of Labor Statistics website. And they wrote– and they're
actually using doublespeak here, I just copied and pasted
it straight from their website –"until the early 1980s, the
CPI used what is called the asset price method to measure
the change in the cost of owner-occupied housing." That makes sense and I'm not
sure whether they just looked at how much houses cost this
year relative to last year and then they put that into the
weighting or they determined the weighting based on people's
average mortgage.

But in general, that's a good
way to measure it, right? Either your mortgage payment, or
how much houses cost. They said, "the asset price method
treats the purchase of an asset, such as a house, as it
does the purchase of any consumer good." Fair enough. "Because the asset price
method can lead to inappropriate results–" And
this is the key line. "Because the asset price method can lead
to inappropriate results for goods that are purchased
largely for investment reasons." I agree with that.

If something is purchased
largely for investment reasons, if I'm purchasing gold,
maybe that shouldn't be included in the CPI, because
it's largely for investment reasons or for stocks. But then they use this kind of
completely disjointed logic. They say, you know, "because
asset price method can lead to inappropriate results for
goods that are purchased largely for investment reasons,
the CPI implemented the rental equivalence approach
to measuring price change for owner-occupied
housing." To me, that makes no sense. Owner-occupied is not purchased for investment reasons. That's a fair enough argument
if you're doing it for rentals, or if you're doing
it for vacation homes. But for actual owner-occupied
housing, this sentence makes no sense. Based on their own rationale,
there's no reason to transfer to this rental equivalent
approach. The whole reason why I'm going
here is, because in the early `80s, I think 1983– they say
it right here, in January, 1983– because they switched
over to this, this kind of inflation that we've seen
in the price of houses, especially the real estate
bubble we've seen the last 10 years, in no way got
incorporated into the inflation numbers.

So it essentially understated
them. You can see that here. Well, two things: not only did
it understate it, but it probably understated the
weighting itself. And Mish, he's had a couple
of posts about this. You really should use
something like the Case-Shiller Index on this line
right here, instead of doing this for owners'
equivalent. But I'd argue one
step further. Not only should you use
something like the Case-Shiller Index, but to
actually gauge this weighting, you should actually survey
people and say, what percentage of your disposable
income is dedicated to your mortgage and other things
related to owning a house? And especially over the last
seven years, I would guess, and I'm almost sure about this,
that it would be much larger than 30% of your
disposal income. So not only was this number
being understated, or the growth in that number, because
it didn't incorporate the increase in housing prices, but
this weighting itself was understated. And just to get a sense of
how much, this is the Case-Shiller Index. And you could look up the
Case-Shiller Index, but, in my opinion, it's the best index
for actual increases or decreases in the
price of homes.

You see from 2001 to 2006
roughly, houses were increasing by 10%
to 15% a year. So if you use that instead of
the rental equivalent, then over the same timeframe– I
don't have a chart for rent, but rent was not increasing at
anywhere near this pace. If anything, people were leaving
apartments to buy houses, so rent was actually
staying pretty stable. But 10% to 15%– this is year
over year growth, this is what this chart is. So 10% to 15%, if you weight
that at 30% of the CPI basket, then really the reported
inflation number was being understated by 3%
to 5% a year. And I'd argue that this
weighting should have grown over that time period because
people were spending more and more of their disposable
income on their mortgage payments. So really it was probably
understanding it by more. Then this weighting should've
been more like 40% and you could have said you're
understanding it by 4% to 6%. And if you look here,
this is the actual reported CPI numbers. What I'm saying is, over that
timeframe, the real inflation number should have
been up here. And then, now that we have
actual deflation in home prices, this is zero.

So now, the most recent
Case-Shiller numbers say that housing has depreciated
by 20%. We're essentially understating
the deflation now. So although right now the CPI
has us at kind of the zero mark, if you actually
incorporated the real prices of homes and you didn't use
rents as a proxy for it, you would actually get a much more
negative number here. And Mish actually did
that on his blog. And if you actually want to read
his blog, which I highly recommend, do a Google search
for Mish, M-I-S-H. And this is directly from his
blog, so I have to give him credit for that. And what he did here is, he
actually charted the actual inflation numbers that
were reported.

That's in blue. And then on top of that, he
put what he calls the Case-Shiller CPI Index
and that's in red. And you see here, especially
over the housing boom– These are the inflation numbers we
got from the government. They peaked out in the 4% or 5%
range, which isn't low by any stretch of the imagination,
and that's probably why the Feds started
increasing interest rates right around here, arguably at
the worst possible time. But if you look at the CS CPI,
or the Case-Shiller CPI, you could almost say that the real
inflation actually peaked out in the 8% range back here.

And you could argue that, if
this was the actual number that the Fed was using, it would
have actually been a much better policy tool, because
they would have seen the inflation pop up back
here in January '03. And they would have known that
they were keeping their monetary policy too loose back
here and they could've avoided this whipsawing that they did
and in 2007 and 2008. And I'd argue even further
that even this number is understanding the reality,
because back here, as a percentage of the actual CPI
basket, he just took the CPI numbers and replaced the year
over year change essentially into the same weighting as
the current CPI numbers.

But if you actually weighted it
based on the actual amount of disposable income people
were spending on their mortgages, I would guess that it
would have looked something more like this. And you would have seen actual
inflation peak out here, probably in the 10%
or 11% range. There's a lot of social
commentary about this; why they do it. One argument is, that a lot of
the government's or even corporate liabilities are
indexed to inflation. You have an inflation index. On the other hand, the sale of
homes essentially transfers wealth from one generation
to another. Especially when you have
a huge increase in the price of homes. If they did this on purpose,
and I'm guessing that they did, it allows housing prices
to increase dramatically. And when housing prices increase
dramatically, it transfers wealth from the new
buyer generation to the retiree generation, so it helps
subsidize the retirees.

And, at the same time, by taking
it out of the actual CPI index, it keeps the
government's, and actually a lot of other corporate,
liabilities low. Because now Social
Security, it's indexed to the CPI numbers. So if the CPI numbers are not
incorporating, are not raising up here, you don't have to
increase people's Social Security payments. And you kind of get to project
this farce to people. You say, oh, in inflation
adjusted terms, you're doing better than your parents'
generation did.

Oh, but, by the way, you can
afford 1/3 the house now. And to some degree that's been
propagated– it's obviously all falling apart now. But the big takeaway from this,
if I had to give you just one, is that the
CPI index is a government created tool. It's based on a survey and, not
only has it not been the same survey, but it's actively
changed over the years. And it's changed in ways that
significantly impact the actual numbers that are reported
and, to some degree, play into what I think
the government wants people to believe.

Anyway see you in
the next video..

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