Washington's Great Inflation Hoax

Billionaire California bond manager Bill Gross calls it "a haute con job." Bloomberg News columnist John Wasik describes it as "a testament to the art of economic spin." More and more shoppers and consumer simply disbelieve it.

The subject of this scorn is the federal government's vaunted Consumer Price Index or CPI. Americans are now beginning to understand that this indicator has its own share of gimmicks not unlike a sub-prime mortgage or the six pages of fine print that accompanies your credit card agreement.

Some of these CPI ingredients -- product substitution weightings, "hedonics" (price reductions for added product quality or satisfaction), and use of owner's equivalent rent (instead of home ownership costs) -- have a comic aspect suitable to mockery by Bill Maher, Stephen Colbert or Jon Stewart. But in a larger sense, they're not remotely funny. That's because the federal minimalization and misrepresentation of inflation, pursued statistically over the last 25 years, has been the main buttress of Washington's over-favorable and self-serving portraiture of the U.S. economy.

Distortions aplenty have followed. Some of the most pernicious include the shortchanging of federal pension and Social Security obligations and cost of living increases, a parallel shortchanging of cost-of-living increases in wage contracts tied to the federal CPI, the suppression of equitable interest payments on bank accounts and certificates of deposit, and the camouflaging of weak U.S. economic growth through inadequate adjustments for inflation. The benefits to the executive branch in Washington jump out -- huge annual federal savings on Social Security and pension outlays, as well as on the amount of interest paid on the federal government's multi-trillion-dollar debt. Some $250 billion a year could be involved.

If many individuals are losers, many businesses and financial institutions have been winners. Minimal cost-of-living increases favor corporations, while low interest rates make money cheaper to the financial sector. In particular, the gargantuan $10 trillion increase in financial-sector debt since 1994 could become unmanageable if mounting inflation forced borrowing costs up to 8% or 9%. And it is axiomatic regarding equities that when rates rise in the bond market, that competition usually undercuts stock market values.

In short, there have been three big gainers from understatement of U.S. inflation: the federal government, wage-paying businesses and the institutions and markets of the swollen U.S. financial sector. But skeptics have a weighty counter: Okay, it's easy to understand how they all might profit from understating inflation. But if the understatement is patently false, how can they hope to get away with it?

In fact, the belief by many conservative U.S. economists that inflation is under control, despite global indications to the contrary (including soaring commodity and energy prices), has a major ideological component -- their fidelity to monetarist economic principles (that only money supply expansion can create inflation) and to the Efficient Markets Hypothesis (that markets process all available information, so that if inflation were serious, markets would have reacted already). As late as January, monetarists on the Federal Reserve Board, notably Chairman Ben Bernanke and colleague Frederic Mishkin, believed in the new-version CPI and argued that U.S. inflationary expectations were safely "anchored."

Financial economists and money managers generally agree. A late April survey of 120 U.S. institutional money managers by Barron's, the financial weekly, found that on average, they predicted a CPI inflation rate of 2.72% in December 2008 and just 2.79% in December 2009. Elsewhere in the world, central bankers and politicians are worrying about another wave of commodity inflation akin to that in the 1970s, but U.S. money managers take comfort in the Efficient Market Hypothesis and in the wisdom and sanctity of the CPI.