As the Federal Reserve's Open Market Committee meets today, we'll likely get an update on how its recent campaign to increase inflation is going. In November, it began another round of asset purchases because it was worried that inflation had become too low, and wanted to ensure that the U.S. wouldn't slip into deflation. Of course, this worry is only valid if inflation actually had been low, which some people deny. Although the official numbers clearly suggest low inflation, can we trust them?

For some reason, arguments that the government's methodology is flawed have become prevalent this week. Today, the Wall Street Journal has a column by Brett Arends that points out several flaws in the government's calculations. Yesterday, Zero Hedge featured a post by Chris Martenson making some of the same claims and others.

A big chunk of the crowd that is angry with how the government calculates inflation thinks that it's simply a part of a grand conspiracy to inflate the U.S. currency. As a result, they often argue for the gold standard, because they assert that will eliminate any potential mistakes. This can be addressed, at length, at a future time. For those of us who aren't conspiracy theorists that see an arbitrary commodity standard as the only answer, there is another alternative: reform the way the price indices are calculated.

Let's look at a few of the major criticisms of the way the Bureau of Labor Statistics measures inflation.

Weighting

In order to calculate a price index, BLS must weighs each sort of good in its basket. Martenson provides a pretty strong argument that the current weighting system has flaws, using health care premiums as an example:

According to the BLS, the average family is projected to have a total exposure to rising health insurance premiums at a rate of only 0.49% (out of 100%). Given a median family income of $49,077 (the 2009 value), this means that the BLS assumes that the average family contributes just $239 dollars per year towards their healthcare insurance premiums. Yes, I wrote per year, not per month. That's not a typo.

Of course, this is possible to improve. There are statistics available on how much money households spend on various goods and services. The weights used should be reviewed and revised to better reflect reality.

Hedonics

BLS also utilizes something called "hedonics" in their methodology. This takes technological changes into account and lowers the price based on purchasing power. An example of this problem is provided by Arends:

Or consider the case of Apple computers. We all know Macs are expensive. And we know Apple doesn't discount. The cheapest Mac laptop today costs $999. A few years ago, it also cost $999. So the price is the same, right?

Ha. Not according Uncle Sam. Using a piece of chicanery called "hedonics," Uncle Sam calls this a price cut. His reasoning? You're getting more for the money. Today's $999 Mac is lighter, fancier and faster than last year's $999 Mac. So the government calculates that the "real" price has actually fallen.

It's pretty to understand why hedonics makes sense in theory. People are getting more technology for their money. But it's also pretty easy to understand why it is flawed -- they are still using $999 to purchase a computer, in the example above. And generally, people don't have an option to buy the older model for cheaper, so they end up spending the same amount of money they did in the past for what is ultimately the same sort of end product.

And that's a possible prescription for how to make hedonics work. In situation where the inferior technology is still available and now cheaper, then it can be taken into account. But in cases where there's no substitute, then the new product's price should be fully utilized.

Backwards Looking Nature

Another complaint from Arends is that the price index is backward looking. Unfortunately, there's no perfect solution to this problem. But you can make sure it's updated regularly so the weights used more accurately depict consumer behavior. One possible methodology could use a 3-year average that resets weights at the beginning of each year. This might be imperfect, but unless something dramatic happens regarding consumer behavior, it shouldn't generally be too far off.

General Mistrust in the Government

Finally, many people who worry about accurate inflation estimates assert that the government simply can't be trusted to make these calculations. But that's easy to fix too -- let third-party, private firms do it instead. Have the government outsource the work to, say, three consultancy firms, banks, or accounting firms that can gather and crunch the data needed to create these reports. Then, average their results. Finally, create a large rotation of a dozen or more of these firms, so that you can ensure that a few firms don't get too cozy with government officials.


There could very well be some validity in the argument that government price indices aren't accurate. But that doesn't mean the solution is necessarily to chuck the whole system. Changes could be made that would provide better inflation statistics.

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