Consumer, Producer, and Import

1. Consumer, Producer, and Import/Export Prices: Debunking Myths, Current Challenges and Current Trends in Inflation Presentation to the Chicago Association for Business Economics April 15, 2010 Mike Horrigan Associate Commissioner Office of Prices and Living Conditions 1

2. 2 Outline of Talk Is BLS understating the rate of consumer price inflation? The view from the blogs. Do BLS import/export price indexes lead to overstating U.S. real GDP growth? Can BLS measure the impact of globalization on domestic inflation? Is BLS overstating the rate of inflation in medical care? A perspective on health care reform Current trends in inflation Critics have accused us not only of incompetence but also of yielding to Administration pressure over the decades. Under both Republican and Democratic administrations, the BLS is accused of having implemented methodological changes for political reasons.Critics have accused us not only of incompetence but also of yielding to Administration pressure over the decades. Under both Republican and Democratic administrations, the BLS is accused of having implemented methodological changes for political reasons.

3. The view from the blogs – CPI The analysis in this section is based on: John S. Greenlees and Robert B. McClelland, “Addressing misconceptions about the Consumer Price Index,” BLS Monthly Labor Review, August 2008, pp 3-19. What the bloggers are saying: William H. Gross, “Haute Con Job” in the October 2004 PIMCO Investment Outlook,  the “faulty and near fraudulently calculated” CPI “may not be a conspiracy but it’s definitely a con job.”

4. The view from the blogs – CPI William H. Gross, in the June 2008 PIMCO Investment Outlook “I’ll tell you another area where we’ve been foolin’ ourselves and that’s the belief that inflation is under control… our CPI numbers (are) not reflecting reality at the checkout counter.” Kevin Phillips, “Numbers Racket: Why the economy is worse than we know,” Harper’s, May 2008, pp. 43-47. “…corruption has tainted the very measures that most shape public perception of the economy”—prominently including the CPI.

5. The view from the blogs – CPI Walter “John” Williams, "Government Economic Reports: Things You've Suspected But Were Afraid To Ask!," Part Four, “The Consumer Price Index,” October 1, 2006 update, http://www.shadowstats.com/article/56. The “CPI “is understated by roughly 7% per year” largely because in recent decades it has “increasingly succumbed to pressures from miscreant politicians, who were and are intent upon stealing income from social security recipients.”

6. 6 Is BLS understating the rate of consumer price inflation? The view from the blogs What the bloggers are saying generally BLS has made numerous methodological changes to the CPI in recent decades. In each case the intent has been to suppress evidence of rising prices. The BLS methods are not consistent with those used in other countries. The changes have had a large impact on the rate of growth of the CPI. Critics have accused us not only of incompetence but also of yielding to Administration pressure over the decades. Under both Republican and Democratic administrations, the BLS is accused of having implemented methodological changes for political reasons.Critics have accused us not only of incompetence but also of yielding to Administration pressure over the decades. Under both Republican and Democratic administrations, the BLS is accused of having implemented methodological changes for political reasons.

7. The view from the blogs – CPI What are the issues or concerns of critics of the CPI in each of the following areas, and what is the BLS view on these criticisms?  Substitution and the use of the geometric mean Quality adjustment and the use of hedonics Treatment of housing – rental equivalence  The use of core inflation by policymakers

8. Substitution and the use of the geometric mean: The bloggers “Cost of living was being replaced by the cost of survival. The old system told you how much you had to increase your income in order to keep buying steak. The new system promised you hamburger, and then dog food, perhaps after that.” Walter “John” Williams, “Government Economic Reports: Things You’ve Suspected But Were Afraid to Ask!” Part Four, “The Consumer Price Index,” October 1, 2006.

9. 9 Substitution and the use of the geometric mean: BLS response The goal of the CPI is to approximate a cost of living index. Operationally, the CPI measures the change in prices for an urban market basket of goods and services. The all-items CPI-U is constructed from 8018 basic CPI indexes, which correspond to 87 geographic units by 211 item categories. 31 large cities with the 56 remaining areas collapsed to represent 7 geographical areas Apples in Chicago, gasoline in San Francisco

10. 10 Substitution and the use of the geometric mean: BLS response BLS assumes no substitution across basic items or areas The Laspeyres formula is used – which holds the market basket fixed as prices change. No substitution of apples for oranges, hamburger for steak, apples in Chicago for apples in Seattle For some basic/area items the Laspeyres formula is used – medical procedures.

11. 11 Substitution and the use of the geometric mean: BLS response BLS began using geometric mean to compute most CPI basic item/area indexes in 1999 Purpose was to reflect consumer substitution in response to relative price change within a basic item/area. Geometric mean reflects substitution among types of steak in Chicago -- only if relative prices change In general, geometric mean yields lower index changes than the Laspeyres index.

12. 12 Substitution and the use of the geometric mean: BLS response BLS has continued to calculate Laspeyres indexes for all CPI basic indexes on an experimental basis for comparison with the official index. The use of the geometric mean for basic item/area indexes led to an overall decrease in the CPI of 0.27 percentage point per year from Dec 1999 to Dec 2007.

13. 13 Quality Adjustment and the use of hedonics: The bloggers What the bloggers are saying: The BLS arbitrarily lowers the CPI by making subjective judgments about quality When a product changes, BLS zeroes out any price change because it assumes quality has improved In using hedonics, BLS is estimating the pleasure consumers get from a good “Comic,” “bizarre” hedonics is “as hard to estimate as it is to take seriously”--Phillips As we read the critics, we realized that they usually didn’t distinguish between quality adjustment and hedonic quality adjustment. They tended to express opposition to any type of quality adjustment, to assume that we measured quality change by measuring pleasure, and that quality is always assumed to go up, never down. Never actually seen anyone describe how hedonics is done and then criticize it.As we read the critics, we realized that they usually didn’t distinguish between quality adjustment and hedonic quality adjustment. They tended to express opposition to any type of quality adjustment, to assume that we measured quality change by measuring pleasure, and that quality is always assumed to go up, never down. Never actually seen anyone describe how hedonics is done and then criticize it.

14. 14 Quality Adjustment and the use of hedonics: BLS response BLS must make adjustments for quality change—package sizes for food, new features in car models, rapid product change -- TVs Hedonics is just one method BLS uses Input cost method Imputation Direct compare We do not estimate “pleasure”; we measure prices of characteristics Hedonic modeling is widely recommended internationally

15. 15 Quality Adjustment and the use of hedonics: BLS response The total weight for all products subject to hedonic adjustments is about 32 percent. Almost all of this total is accounted for by shelter and apparel items For which BLS has used hedonic models for roughly two decades. The expansion of hedonic models starting in 1999 to personal computers, microwave ovens, televisions, etc have a combined weight of about 1 percent in the CPI.

16. 16 Quality Adjustment and the use of hedonics: BLS response BLS estimates that the use of hedonic models has increased (not decreased) the annual rate of change in the all-items CPI-U, But only by .005 percent per year. We do note that one aspect of quality change that BLS is unable measure is the welfare loss or gain to the consumer associated with a change in product variety.

17. 17 The treatment of housing - rental equivalence Until the 1980s, homeowner shelter costs were measured by new house prices, mortgage interest, and other out-of-pocket components In a high-inflation environment, this approach led to volatile, and questionable, index movements The mortgage interest cost index rose 40.3 percent in the year ending March 1980 CPI-U switched to rental equivalence (imputing owner costs from rents) in 1983, CPI-W in 1985

18. 18 Rental equivalence: The bloggers According to the bloggers - the intent, and effect, of rental equivalence was to suppress measured price increases And because it excludes house prices, the CPI fails to reflect the true cost of housing The CPI index for Owners’ Equivalent Rent (OER) is based on the concept of opportunity cost. What is the foregone rent they would have received had they not consumed the services of their home.

19. Rental equivalence: BLS response The alternative, the use of house prices to measure homeowner cost, known as the asset based approach, would combine consumption and investment features of a home. Unlike other items, if an asset approach were used, inflation in housing prices would be viewed as a good thing from a return on investment point of view. The impact of the recent fall in housing prices would have had on the CPI -- at the same time that energy and food prices were rising rapidly would have been very difficult to explain.

20. Rental equivalence:BLS response Comparison of OER (CPI-U) with the asset based approach in CPI-W between 1983 and 1985: OER price indexes rose faster than the asset based house price indexes in the CPI-W. Long-term comparison of the OER price index in CPI-U with the National Association of Realtors (NAR) index of monthly principal and interest payments required to purchase a median priced home NAR rose 79% between 1983 and 2007 OER rose 140% over the same time period

21. 21 Core Inflation: The bloggers The Core is a means of hiding inflationary pressure BLS began issuing the Core at Richard Nixon’s request, in order to show less inflation BLS highlights the Core or the All Items depending on which rises least BLS has deleted Food and Energy from the CPI Social Security is indexed by the Core Not all critics believe all these things, but they are common myths.Not all critics believe all these things, but they are common myths.

22. 22 Core Inflation: BLS response The Core is just one of thousands of indexes the CPI publishes each month For example, All Items Less Medical Care or Commodities Less Food The CPI reporting format does not change from month to month BLS does not claim the Core has predictive or analytical value Indexed federal benefit and social assistance programs use the All Items CPI-W or the CPI-U

23. 23 Methodology Impacts: The Criticism According to Shadowstats, CPI inflation would be much higher if the BLS used older methods: Using 1990 methods, the 12-month inflation rate would now be about 7 percent per year (not 3.7 percent) Using 1980 methods, the inflation rate would now be almost 12 percent per year Shadowstats’ John Williams claims to have “reverse engineered” the BLS changes

24. 24 Methodology Impacts: Our Response The geometric mean impact is only .28 percent annually The aggregate impact of new (1998 and later) hedonic models is near zero Currently, use of an asset-based method for homeownership would reduce the CPI The Shadowstats estimates are implausible They imply a continuous, catastrophic decline in US real incomes over the last 10 years For example, from April 1998 to April 2008, a 7%

25. 25 Outline of Talk Is BLS understating the rate of consumer price inflation? The view from the blogs. Do BLS import/export price indexes lead to overstating U.S. real GDP growth? Can BLS measure the impact of globalization on domestic inflation? Is BLS overstating the rate of inflation in medical care? A perspective on health care reform Current trends in inflation Critics have accused us not only of incompetence but also of yielding to Administration pressure over the decades. Under both Republican and Democratic administrations, the BLS is accused of having implemented methodological changes for political reasons.Critics have accused us not only of incompetence but also of yielding to Administration pressure over the decades. Under both Republican and Democratic administrations, the BLS is accused of having implemented methodological changes for political reasons.

26. Do BLS import/export price indexes overstate U.S. real GDP growth? Mike Mandel

27. Measuring price change in the era of globalization As producers switch from internal or domestic sourced supply to foreign sourced suppliers for inputs, BLS fail to capture the associated price drops. If we don’t account for these falling prices, then we are overestimating the rate of price inflation for imports, and underestimating the value of real imports. Real GDP = C + I + G + (X-M) If we underestimate real M, we are overestimating real ‘domestic’ GDP, and by default the productivity of the U.S. economy.

28. Measuring price change in the era of globalization The PPI is an output based price index. We measure the payments received by producers for the production of output or the provision of services. To the extent that falling input prices are reflected in falling domestic output prices, then we do capture that impact in domestic inflation – both for PPI finished goods and CPIs.

29. Measuring price change in the era of globalization In terms of deflators for imports, our import indexes do not reflect price drops as the sourcing of imports switches from domestic to foreign based. When the sourcing of an input switches from one foreign country to another, however, we do capture this price drop The prices paid for an input is not part of our current methodological approach.

30. Measuring price change in the era of globalization One way to capture these price drops is to develop an input price index. Such indexes would reflect price drops for inputs regardless of source. These indexes would provide more direct measures of input inflation for the BEA input-output tables.

31. Measuring price change in the era of globalization Challenges still remain:  The distinction between manufacturing and wholesale trade Classification of goods and services is not seamless between PPI and IPP Prices at the border do not capture global supply or value chains

32. 32 Outline of Talk Is BLS understating the rate of consumer price inflation? The view from the blogs. Do BLS import/export price indexes lead to overstating U.S. real GDP growth? Can BLS measure the impact of globalization on domestic inflation? Is BLS overstating the rate of inflation in medical care? A perspective on health care reform Current trends in inflation Critics have accused us not only of incompetence but also of yielding to Administration pressure over the decades. Under both Republican and Democratic administrations, the BLS is accused of having implemented methodological changes for political reasons.Critics have accused us not only of incompetence but also of yielding to Administration pressure over the decades. Under both Republican and Democratic administrations, the BLS is accused of having implemented methodological changes for political reasons.

33. Is BLS overstating the rate of inflation in medical care? A perspective on health care reform By design, health care reform has the goal of increasing access to care and reducing out of pocket costs (on average) for consumers. CPI measures the out of pocket payments by consumers for medical care goods, services, and health insurance. CPI indexes will play an important role in measuring the real costs of health care reform to the consumers of health care goods and services.

34. Is BLS overstating the rate of inflation in medical care? A perspective on health care reform Producer Price Indexes for health care goods and services are designed to capture payments received by producers for the provision of these goods and services – regardless of the source of payment. By construction, PPIs will be an important source of information for tracking the real costs of the provision of total health care.

35. Is BLS overstating the rate of inflation in medical care? A perspective on health care reform CPIs and PPIs follow individual goods and services. The provider of a good or service is a price determining characteristic. For example, ulcer surgery with its DRG code is a service with a probability of selection for the medical care services provided by hospitals.

36. Is BLS overstating the rate of inflation in medical care? A perspective on health care reform Similarly, ICD9 codes for the treatment of an ulcer at a doctor’s office and a pharmaceutical agent for the treatment of an ulcer from pharmacies are eligible for selection for pricing. What happens in our price indexes when the predominant treatment for ulcers switches from a surgical to a pharmaceutical agent?

37. Is BLS overstating the rate of inflation in medical care? A perspective on health care reform We do not have a formal price index classification structure or data collection process to capture the treatment of ulcer disease. We don’t show the price drops to the consumer or the changing revenues received by producers as the delivery of treatment switches from ulcer surgery to a pharmaceutical agent.

38. Is BLS overstating the rate of inflation in medical care? A perspective on health care reform This problem is similar to the one described in terms of capturing price drops as input sourcing crosses domestic to foreign sourced. Here we do not capture the price drop as treatment protocols cross provider classes. Comparative effectiveness research that is part of health care reform – models of treatment protocols by disease – serve to underscore the importance of capturing the impact of changing protocols.

39. Is BLS overstating the rate of inflation in medical care? A perspective on health care reform The 2007 Census of Establishments for the medical care industry included the collection of revenue by Disease category. ICD-9, DRG, Pharmaceutical agents can be aggregated up to a disease based classification system Example: Treatment of diseases of the cardiovascular system BLS / PPI plans to produce disease based price indexes that capture the effect of changing revenue weights across provider classes as disease protocols change

40. Is BLS overstating the rate of inflation in medical care? A perspective on health care reform How big is the impact of changing treatment protocols on measured health inflation? Researchers at BLS have modeled this effect for CPI by using data from the Medical Expenditure Panel Survey as the source of revenue weights organized by the treatment of disease. As the treatment of ulcers switches from surgery to a pharmaceutical basis, the associated total and relative sales revenues (weights) will also change.

41. Is BLS overstating the rate of inflation in medical care? A perspective on health care reform The weights are multiplied by the observed prices to form a price index for the treatment of a disease – combining the prices of surgery and pharmaceutical agents into a disease based index. Preliminary analysis suggests that the impact of measuring health inflation by disease treatment versus separate indexes for each treatment provider/protocol makes little difference.

42. 42 Outline of Talk Is BLS understating the rate of consumer price inflation? The view from the blogs. Do BLS import/export price indexes lead to overstating U.S. real GDP growth? Can BLS measure the impact of globalization on domestic inflation? Is BLS overstating the rate of inflation in medical care? A perspective on health care reform Current trends in inflation Critics have accused us not only of incompetence but also of yielding to Administration pressure over the decades. Under both Republican and Democratic administrations, the BLS is accused of having implemented methodological changes for political reasons.Critics have accused us not only of incompetence but also of yielding to Administration pressure over the decades. Under both Republican and Democratic administrations, the BLS is accused of having implemented methodological changes for political reasons.

43. 12-month percent changes, not seasonally adjusted, CPI-U, PPI Finished Goods, Exports, and Imports, Jan 2007 – Jan 2010

44. Consumer price inflation, selected periods, seasonally adjusted annual rates

45. Producer price inflation for overall, food, energy and core finished goods, selected periods, seasonally adjusted annual rates

46. Import price inflation, selected periods, not seasonally adjusted annual rates

47. Export price inflation, selected periods, not seasonally adjusted annual rates

48. Mike HorriganAssociate CommissionerOffice of Prices and Living Conditionswww.bls.gov/202-691-5735horrigan.michael@bls.gov