published Wednesday, April 20th, 2011

Personal Finance: CPI does not reflect your spiraling costs

By Chris Hopkins

Last Friday we received the encouraging news that the consumer price index is up a mere 2.7 percent over the past year, and that the so-called “core” CPI excluding food and energy rose a paltry 1.2 percent.

According to the Federal Reserve Board, inflation remains well contained.

Yet consumers continue to encounter higher prices on nearly everything from tires to toothpaste.

How can we reconcile the apparent discrepancy between the official numbers and our actual experience?

The consumer price index is the broadest and most iconic measure of the relative prices of goods and services in the United States.

It is compiled by the Bureau of Economic Analysis each month, and represents the relative price movement of a fixed basket of common products and services.

Because the contribution of energy prices and food costs tends to be highly variable,

another measure called the core CPI strips out those two components and therefore tends to fluctuate less in the short run.

The core number is more useful from a policy standpoint since it tracks the central tendency of inflation but is less volatile month over month.

Even after excluding gasoline and food, most of us would agree that prices of the items we buy every day are rising faster than 1.2 percent per year.

One reason for this disconnect is the way the government measures housing costs. Rather than tracking the market value of an owner-occupied home, the price index includes an estimate of the amount of rent the homeowner could charge a theoretical tenant. This so-called “owner equivalent rent” or OER is intended to make housing cost estimates more comparable and remove some of the inherent volatility in home prices.

The rental estimate makes up a fourth of the CPI and about a third of the core CPI. Since owner equivalent rent has fallen dramatically with the decline in real estate values, the impact of higher prices for many other consumer goods is dampened in the CPI calculation by the large drag from lower imputed rents.

During the previous decade, the real estate boom supercharged a CPI that overstated realized inflation at the individual level. We are now enmeshed in the inverse situation in which the retail price inflation we clearly experience in everyday purchases is currently not fully reflected in the headline inflation gauge.

As home values recover, the index will revert toward a more meaningful reflection of everyday price behavior.

Chris Hopkins is a certified financial analyst and vice president of investments at Barnett & Co. Inc. His personal finance column appears every other Wednesday.

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