• Are inflation data accurate?
• If not, our view of the economy is distorted
• What appears to be growth could in fact be stagnation

“There are three kinds of lies: lies, damn lies, and statistics.” – Mark Twain, attributed to Prime Minister Benjamin Disraeli.

Earlier this month, the UK released the September 2024 inflation figures (CPIH), showing that the consumer price level increased by 2.6% over the past year. Not 2.5% or 2.7% but 2.6%.

How confident should we be that this figure is accurate? As it happens, not very confident at all. Allow me to explain…

As with all economic aggregates, the CPI is estimated by compiling large amounts of data. Within the CPI there are numerous subcategories, each of which is given a weighting. Within each subcategory there remains a large basket of relevant goods, each with its own weighting within that basket.

In all cases, the baskets and subcategories are reweighted from time to time based on estimates for how a typical household’s consumption patterns change over time. For example, wireless data services used to be a negligible component of the CPI. Today, however, this comprises roughly 2% of the overall index.

If any of the above measurements, weightings, estimates and aggregation methodology seem at all subjective to you, of course you are right. No process of aggregating what happens in the real, objective world is possible without some subjectivity—guessing even—entering the process.

As economist Roger Garrison once said, “Your aggregate IS your theory.” The assumptions economists make don’t just influence how they see the economy: When it comes to creating an economic aggregate, they define it.

Perhaps the best example for how subjective the CPI can be is found in the way the calculation methodology has changed over time, including the introduction of substitution effects and so-called ‘hedonic’ adjustments within the index. The former is for when a given good rises in price, but a near-substitute does not. The CPI methodology assumes that when this happens, consumers will shift their purchases away from the more expensive to less expensive substitute good, thereby lowering the overall effect on the CPI. A classic example here would be steak and hamburger meat. If the former rises in price, consumers simply shift their purchases to the latter.

Hedonics are even more subtle, more subjective and thus even more controversial adjustments to the CPI methodology. Introduced in the 1990s, they attempt to adjust for increases in the quality of consumer goods over time. For example, computers may not get less expensive, but they may become more powerful. In this case, hedonic adjustments would imply that the ‘price’ of computers had fallen as a result.

Cars may not get more expensive, but they might get better fuel mileage and be safer. Here, too, hedonics would imply that their prices are falling. (Intriguingly, hedonics are not applied to the reverse effect, that is, were the quality of some good or service to decline over time, for whatever reason.)

The obvious problem with adjustments such as these is that they introduce even greater subjectivity into a calculation methodology that was already subjective. While for a majority of households, the CPI might do a fair job tracking their real, effective cost of living, for a sizeable minority, it might not.

Take, for example, the huge divergences in trends within the CPI subcategories in recent years. When it comes to goods that can be manufactured abroad and are thus subject to significant international competition, there has been essentially zero price inflation and, in some cases, outright deflation for years, as seen in basic clothing, some household goods and electronics prices.

However, when it comes to domestic services—in particular education, childcare, healthcare and other highly-regulated sectors subject to little if any international competition—price increases have been running at much higher rates. Thus, a household with children might well have faced an effective inflation rate of double or more versus the average annual CPI in recent years.

During the same period, an elderly, retired couple with no children and with access to government-funded healthcare and other programmes available to senior citizens might well have experienced a near-zero average increase in their cost of living.

Many years ago, US business economist and forecaster John Williams noticed that a large divergence had opened up between the older, pre-substitution and hedonic CPI and the newer methodology. He began tracking both and eventually set up a research firm, ShadowStats (www.shadowstats.com).

Here is an excerpt from his website explaining the discrepancy that he had found:

Measurement of consumer inflation traditionally reflected assessing the cost of maintaining a constant standard of living, as measured by a fixed-basket of goods. Maintaining a constant standard of living, however, is a concept not popular in current economic literature, and certainly not within the thinking or the lexicon of the Bureau of Labor Statistics (BLS), the government’s statistical agency that estimates and reports on consumer inflation.

The changing costs of maintaining a constant standard of living were measured by pricing out a fixed-basket of goods and services—same components, same weighting—period after period. Whatever the percentage change was in the cost of that basket of goods, that is how much income would have to rise in order for someone to maintain a fixed- or constant-standard of living over the given period. At least it was a reasonably consistent approximation of same.

In the early-1990s, political Washington moved to change the nature of the CPI. The contention was that the CPI overstated inflation (it did not allow substitution of less-expensive hamburger for more-expensive steak). Both sides of the aisle and the financial media touted the benefits of a “more-accurate” CPI, one that would allow the substitution of goods and services.

The plan was to reduce cost of living adjustments for government payments to Social Security recipients, etc. The cuts in reported inflation were an effort to reduce the federal deficit without anyone in Congress having to do the politically impossible: to vote against Social Security. The inflation-calculation changes had the further benefit to government fiscal conditions of pushing taxpayers artificially into higher tax brackets, thus increasing tax revenues.

It’s as if the scales have been tampered with, leading to higher effective tax rates and reduced government benefits payments.

If you visit www.shadowstats.com you will find some charts and data that show the discrepancy between the current, official US CPI and Mr Williams’ alternatives, based on older methodologies. These indicate that CPI could be as much as 5% higher than official estimates, especially when inflation is running hot.

The implications of this are profound. If CPI is overstated by 5%, then real growth is understated by 5%. The US is in recession, rather than growing. (That might help to explain why, as discussed in part 1 of this series, the US is shedding productive, full-time jobs and adding relatively unproductive part-time jobs instead.)

In case you are wondering, the UK Office of National Statistics uses much the same modern CPI methodology as the US. Similarly trained economists developed both. Thus, Mr Williams’ observations about US inflation data are highly likely to be applicable to the UK too.

Could it be that the UK economy is actually in recession, rather than growing? Perhaps. But the most important lesson here is that economic data are not bulletproof. They can be subject to mismeasurement, large revisions, changed methodologies and so on.

And like the rest of us, economists are human. They can and do make mistakes. They might have biases. They might also do what their superiors tell them to, even if they disagree with some or all of the details.

Don’t trust everything you read in the papers or see on television or social media. And, to paraphrase former Prime Minister Benjamin Disraeli, always be on the lookout for “lies, damn lies and economic statistics!”

And as you know, here at Southbank Investment Research, we never take the news at face value. We dig deeper, uncovering what’s being left unsaid – and our latest discovery is something you won’t want to miss.

For 228 years, our leaders have been making you pay billions in taxes because of someone who died 203 years ago… and now, this costly “bloody butcher’s bill” could be about to soar even higher.

To learn why and what you can do before Labour’s “Wealth Waterloo” budget, click here now.

Until next time,

John Butler
Investment Director, Fortune & Freedom