Consumer Price Index (CPI), A Standard of Living Problem

By: Chris_Riley

The CPI is a cost of living indicator, calculated with a basket of goods that varies over time. As it is attempting to measure price changes in a typical consumption basket, it does not compare price changes across a like-for-like basket of goods over time. This has caused large under measurement of the true rate of price inflation when living standards have been falling and over measurement of price inflation when living standards have been rising. This is a major problem, as we need to measure price changes whilst holding the standard of living constant i.e. across a fixed basket of goods. But that would invalidate the CPI as a measure of change in the cost of living.

As living standards fall, people switch into lower quality goods. This then affects the composition of goods within the CPI basket as consumption patterns have changed. The deterioration of goods within the CPI basket causes a downward bias, as the comparison within the basket is not like-for-like over time. An example of such a period would be the 1970’s. We observe here a large downside deviation in the CPI calculation, relative to the change in price of physical commodities such as gold or oil, which are not deteriorating in quality.

During times of economic expansion, incomes increase and people switch into higher quality goods. This change in consumption patterns leads to an upward bias in CPI relative to commodity prices. An example of such a period is 1980-2000.

From 2000 onwards, we have switched back to a time of economic destruction. Standards of living are on the decline and once again the CPI is heavily under-representing the true rate of price change.

In order to measures price changes across a constant standard of living, it is useful to measure the price movement of physical commodities (where quality does not vary). An ounce of gold is still an ounce of gold & a barrel of oil is still a barrel of oil, regardless of any changes in living standards. This strips away the distortions of the CPI measure. This was how price inflation was measured in the past: currencies were pegged to the price of gold, under the Gold Standard. It remains a useful way to deflate asset class returns today.

By Chris Riley

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