Albert Einstein, a man who knew a thing or two about celestial mechanics, supposedly once called compound interest "the most powerful force in the universe." While the remark was likely meant to be funny (astrophysicists can be hilarious), it sheds light on the often overlooked fact that small changes, over time, can yield enormous results. Over eons, small creeks can carve large canyons through solid rock. The same phenomenon may be at work in our economy. A minor, but persistent under bias in the inflation gauge used in the Gross Domestic Product (GDP) may have created a wildly distorted picture of our economic health.
It would be impossible to measure the economy without "backing out," inflation. That is why economists are very careful to separate GDP reports into two categories: "nominal" (which are not adjusted for inflation), and real (which are). Only the real reports matter. The big question then becomes, how do we measure inflation? Just as I reported last week with respect to the biases baked into the government's GDP revisions, the devil is in the details.
As it turns out there are a number of official inflation gauges that vie for supremacy. Most people tend to follow the Consumer Price Index (CPI) which is compiled by Bureau of Labor Statistics, a division of the Department of Labor. The CPI is regarded as the broadest measurement tool, but it has been changed many times over the years. Most famously, its formulas were loosened in the late 1990's as a result of the "Boskin Commission" which said that the CPI overstated inflation by failing to account for changes in consumer behavior. I believe those changes seriously undermined the reliability of the index. But the CPI itself has to contend for relevance with its stripped down rival, the "Core CPI," which factors out food and energy, which many believe are too volatile to be accurately counted. The core CPI is almost always lower than the "headline" number.
Another set of inflation data, the "GDP Deflator" is compiled by the Bureau of Economic Analysis (part of the Commerce Department), and is used by them to calculate GDP. The deflator differs from the CPI in that it has much more flexibility in weighting and swapping out items that are in its sample basket of goods and services. While the CPI attracts the lion's share of the media and political attention, it is the deflator that is relevant when looking at economic growth.
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