Inflation Outlook: What the higher ?unofficial? rate means for the economy

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If you?re like the average American, when you fill up your car at the gas pump, you?re paying 84 percent more than you were in 2000, for an average price rise of 12 percent per year, according to data from the U.S. Bureau of Labor Statistics.

The cost of many of the goods in your grocery basket has risen between 4 percent and 5 percent per year. The cost of electricity has risen 4 percent a year, while natural gas has risen 8 percent. And medical care has gone up about 5 percent a year, according to those same data.

Those rates of inflation?the kind of price rises that Americans feel on a daily basis?are often far higher than the official rate of inflation, which has increased an average of 2.6 percent per year since 2000. Although the official inflation rate includes many items that decline in price, such as consumer electronics, discrepancies such as that lead many economists to question whether the government is undercounting the inflation rate. ?Any housewife can tell you that the official inflation rate is just not true,? says William Rutherford, a former Oregon state treasurer who runs an investment management firm near Portland. ?If you don?t drive or don?t eat, maybe the CPI (consumer price index) has a little resemblance to your life. But I don?t see how anybody with any ordinary experience could see the CPI is being accurate,? Rutherford says.

Rewritten Calculations
Rudolph-Riad Younes, a co-manager of the Julius Baer International Equity Fund, told Barron?s magazine recently that if the government counted home prices and energy correctly, the real inflation rate would be between 7 percent and 10 percent. John Williams, a Dartmouth?trained economist who works as a consultant for a number of Fortune 500 companies, says the only reason the inflation rate is so low is because the Reagan and Clinton administrations rewrote the way the CPI is calculated. In his monthly online newsletter, Shadow Government Statistics, Williams has painstakingly attempted to re-create the inflation rate using its older guidelines. Under his calculations, inflation is actually running at an annual rate of 9.95 percent.

Steve Reed, an economist at the Bureau of Labor Stand-ards, which maintains the CPI, concedes that ?you do get a lower (CPI) because of the changes we?ve made.? He says today?s CPI might be between half a point and a full point higher using the old methods of calculation. ?The numbers (that Williams uses) don?t jibe with what I?ve seen,? Reed says. He says the current CPI rate is accurate, but adds that the government does have a vested benefit in keeping the rate lower.

Understating the inflation rate can save businesses and the government money, although it can be a burden on the elderly, people on fixed incomes or salaried workers, since wage raises, pension benefits, welfare payments, Social Security payments and other items are tied to the CPI. ?Even if the CPI was one percentage point higher, it could cost the government hundreds of millions of dollars,? Reed says.

Inflation is likely to spike further, thanks to the Federal Reserve, which has pumped money into the economy to support an interest-rate cut. ?Since the increased supply of money does not come from productivity and savings, there is no increase in goods and services to absorb the new money,? says Michael Pento, a market strategist with Delta Global Advisors in Huntington Beach, Calif. ?And therein lies the problem: The result of an increased money supply without increases in productivity is higher prices. Inflation.?

Drawing Ire
One change that draws criticism is the CPI?s use of ?substitutions.? The consumer price index assumes that if prices get too high, consumers will start buying cheaper products. As a result, when items in the CPI?s basket of goods get too expensive, the weight that they are given in the index is lessened and more weight is put on cheaper substitutes. Naturally, that helps keep the CPI lower. Williams says such a move ?violates the original intent, purpose and concept of the CPI,? which was to measure the costs of the same goods year after year.

Reed disagrees. ?We?re not substituting beef for chicken, or driving for flying,? he says. ?The weight of academic expertise would argue that what we did was right.?

Another factor that draws ire is the CPI?s reliance on high-ticket items?DVD players, audio equipment, televisions. Six percent of the CPI is based on video and audio equipment, sporting goods, cameras and recreation, compared with 8 percent that is spent on food at home. Critics say that the concentration on high-tech items?which typically decline in price over time?disguises the price rises in other areas. They also say that the CPI reflects upper-class tastes and expenses that might not catch the price hikes for poorer individuals. ?If I?m not a terribly wealthy person, that might not reflect how I?m spending my money,? Reed says.

The mix of items in the CPI has left some critics scratching their heads.
Since the Reagan administration, for instance, the CPI costs for housing have been based on rental costs, rather than home ownership. As a result, between 2000 and 2006, when home prices were skyrocketing, the CPI showed a price rise of only 3.3 percent per year. Property tax payments, which typically rise with the value of a house, are not counted in the CPI. ?We wanted to be out of the business of dealing with interest rates and interest expenditures,? Reed says. ?The true value is more accurately reflected in its rental value.?

Surprising Consequences
The low growth rate in the CPI can have surprising consequences. Over the past four years, for instance, the cost of construction materials rose 28 percent, while the CPI rose only about 13 percent. When construction companies work on government projects?where contracts are typically tied to the CPI?they sometimes have to cut corners to make up for the fact that their supply costs are rising more than twice as fast as the inflation rate, says Kenneth Simonson, an economist for the Associated General Contractors.

John Browne, a former British parliamentarian who is now a financial commentator in Florida, says the low inflation rate also helped fuel the bubbles in dot-com stocks and real estate. ?The great inflation lie enabled the banking system?first under former Federal Reserve Chairman Alan Greenspan and now under current Chairman Ben S. Bernanke?to lend lots of money at rates that were sometimes below the rate of inflation,? Browne says. ?If you can borrow for less than inflation, you can buy anything, including assets like houses.?

More Inflation
Now that the housing bubble is bursting, Bernanke?s response has been to inject more money into the economy, which economists fear will create more inflation. Market strategist Pento says that even if the CPI doesn?t show strong inflation now, other measures do, including this year?s surges in the price of gold and the money supply. ?Gold and the money supply are true inflationary indicators,? Pento says. ?If they?re growing at that pace, inflation is at least in the upper single digits. At least.?

Pento warns that it is risky for the Federal Reserve to start cutting interest rates when inflation is running at such ?very dangerous levels.?
David Joy, chief market strategist for RiverSource Investment, says he worries that the latest interest-rate cut means that ?eventually, and possibly sooner now than otherwise, the Fed will be forced to deal with higher inflation, accelerating the day of reckoning and making it more painful.?