- The Washington Times - Sunday, June 5, 2005

Consumer prices are higher this year, but some specialists say even the measured rise in inflation does not reflect the rapidly rising costs consumers encounter every day.

G.B. Bose, a Bethesda financial executive and father, was shocked when he took his family to the movies recently and had to pay $25 for popcorn and snacks.

“It was $3.40 for one scoop of ice cream. Is that legal?” he joked, noting that a scoop was only 25 cents in the 1970s when he arrived from his homeland of India.

“I keep hearing that inflation is under control. But are prescription prices under control? Gas? I don’t think so,” he said.

The much-watched Consumer Price Index (CPI) has doubled to 3.5 percent since 2002, fed mostly by higher energy prices. The pace of increase in the last three months was faster still at 6.2 percent, according to the Labor Department, which publishes the index.

But outside the volatile food and energy areas, according to the surveys, prices appeared to be tame. In April, the so-called “core” price index — which covers everything from clothing to medical care and housing — did not increase at all.

The absence of core inflation sent Wall Street markets into a frenzy. But the report only raised eyebrows among some consumers who say they are spending more and more each month to get the same amount of health care, education and other core items.

Some economists think the price measure is not reflecting everyday realities. They note a disconnect between the government’s inflation reports and what consumers say they are experiencing.

A critical area of contention is housing, which constitutes a third of the overall price index. Nearly 70 percent of Americans own their homes, and they have seen steep increases in their home values in the last five years — culminating in a 15 percent jump in home prices nationwide in the past year.

Home prices in the Washington area have doubled or tripled in many neighborhoods, and the cost of maintaining, heating, cooling and improving homes also has been soaring.

Yet the department’s housing cost index rose only by 2.7 percent in the past year — a discrepancy that has economists scratching their heads.

“The core CPI considerably misrepresents what is happening in the housing market,” said John Silvia, chief economist at Wachovia Securities, who added it’s “time to can the core.”

The problem with the housing index, economists say, is it does not measure the cost of owning a home but rather reflects the cost of renting, which has been rising much more slowly than the cost of home purchases and upkeep.

While over time the cost of renting normally rises and falls with the cost of owning, the relationship can at times be distorted. Recently, the cost of rent has fallen dramatically as a percentage of a home’s price — an unusual development that economists say could be evidence of a price bubble in the housing market.

Normally, the annual cost of rent should be between 6 percent and 10 percent of the home price, according to John P. Calverley, chief economist at American Express Bank.

Last year, the ratio of rental income to home prices dropped to 3.5 percent nationwide and was even lower in areas of the East and West coasts — including Washington — where housing inflation has been the highest.

Economists who defend the housing cost index say it eventually will catch up with the surging costs of homeownership — which means the housing index will be a major force driving up inflation in the years ahead.

Some specialists say the failure of high homeownership costs to filter through to rent increases is just more evidence that the forces of disinflation remain strong. They say businesses — including property owners — have no power to raise prices even when their costs are going up.

Bill Gross, managing director of the Pimco bond funds, said housing and a few other sectors of the U.S. economy may be overheated and exhibiting inflation, but the price pressures there are overwhelmed by the disinflationary forces that prevail in the world outside the United States.

The influence of global disinflationary forces is most evident in the falling prices for imported goods, such as technology and clothing. Computer prices, for example, dropped by 16 percent in the last year, while women’s apparel prices fell by 1.8 percent.

Lower costs overseas also work indirectly to keep a lid on prices in the United States, particularly by holding down labor costs in industries that compete with China and other nations where the cost of labor is only a fraction of U.S. levels.

Labor costs, which constitute as much as two-thirds of a business’s overall expenses, have been particularly subdued since the 2001 recession. Many American workers have been getting no raises at all, or wage gains that are less than the rate of inflation.

“With a globalized free-trade-based economy, it will be difficult to generate U.S. inflation higher than our current 3 percent,” said Mr. Gross. “What inflation we do have — 3 percent in the United States, 2 percent in Euroland and zero percent in Japan — is due to asset inflation: higher commodity prices, higher housing prices, higher stock prices.”

As the debate over inflation rages, another important aspect of the Consumer Price Index has come under fire: a system of “quality adjustments” the department introduced nine years ago to take into account improvements in the performance of products that may justify price increases.

Under the department’s new procedures, the shelf price of a computer may be the same this year as last year, for example, but the department’s index would show a drop in price if the computer’s processing speed or other capabilities have been upgraded.

Thus, according to department computations, computer prices have plunged 70 percent over the past five years and television prices have dived 46 percent — all largely because of improvements in performance rather than actual drops in their retail prices.

The American Institute for Economic Research — a Massachusetts Institute of Technology think tank which has been chronicling inflation trends since the 1930s — contends that inflation has become seriously understated because of the department’s quality adjustments.

In an example of a quality adjustment noted by the institute, the sticker price of a new car may go up by $200, but the department records no increase if it was due to $200 worth of air-bag improvements.

“The increase may not show up in the price index, but it still shows up on your bill,” said Kerry Lynch, research director of the institute. The quality adjustments “are one of the main reasons the CPI often differs from the price changes people observe,” she said.

The institute contends that the department’s methods are suspect because they were instituted at a time when the Clinton administration and Congress were looking for ways to cut the budget deficit. Political leaders viewed the price adjustments as an unobtrusive but powerful way to save the government money.

The price index is used to determine inflation adjustments each year in Social Security and other government-benefit programs that constitute a big and growing share of the federal budget.

Retirees are unlikely to notice a small reduction in cost-of-living adjustments in their benefit checks each month, they reasoned, but the change can save the government hundreds of billions of dollars over time.

Political leaders got a boost from Federal Reserve Chairman Alan Greenspan, who was the most influential advocate for changing the price index to better reflect improvements in quality — especially for technology goods that were getting noticeably better every year.

The changes were made in the sincere belief they would improve the accuracy of the price index, said Ms. Lynch. But in retrospect, it appears they created another distortion — that of understating inflation, she said.

“There will never be a perfect price index,” she said. But without action to correct the new “bias” in the index, “the gap between the official numbers and the prices that you observe in daily life is likely to widen.”

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