Economists' programs are beating U.S. at tracking inflation

By Annie Lowrey
Saturday, December 25, 2010; 11:35 PM

At 23,000 retailers and businesses in 90 U.S. cities, hundreds of government workers find and note prices on very precise products. And I'm not kidding when I say "very precise."

Say the worker is finding the price for a motel room. She might write a report like this: Occupancy - two adults; Type of accommodation - deluxe room; Room classification/location - ocean view, room 306; Time of stay - weekend; Length of stay - one night; Bathroom facilities - one full bathroom; Kitchen facilities - none; Television - one, includes free movie channel; Telephone - one telephone, free local calls; Air-conditioned - yes; Meals included - breakfast; Parking - free self parking; Transportation - Transportation to airport, no charge; Recreation facilities - an indoor and an outdoor pool, a private beach, three tennis courts and an exercise room.

This mind-numbingly tedious process goes on for a dizzying panoply of items: wine, takeaway meals, bedroom furniture, surgical procedures, pet dogs, college tuition, cigarettes, haircuts, funerals. When all of the prices are compiled, the workers submit forms that are collated, checked and input into massive spreadsheets.

Then the government boils all those numbers down to one. It weights certain prices, taking into account that consumers spend more on rent than cereal, for instance. It considers product improvements and changes in spending habits. Then it comes up with a master number showing how much a customer's spending needed to increase to buy the same goods, month-over-month. That number is the Consumer Price Index, the government's main gauge of inflation.

Each month, the Bureau of Labor Statistics goes through all that hassle because knowing the rate of inflation is such an important measure of economic health - and it's important to the government's own budget. High inflation? Savers panic as the spending power of their accounts erode. Deflation? Everyone saves, awaiting cheaper prices in a few months. And wildly changing inflation makes it difficult for businesses and consumers to make economic decisions. Moreover, the government needs to know the rate of inflation to index certain payments, like Social Security benefits or interest payments on TIPS bonds.

Even though the government expends so much energy determining the rate of inflation, it may not be tallying it in the smartest or most accurate way. The reigning methodology is, well, clunky. It costs Washington about $234 million a year to get all those people to go and bear witness to a $1.57 price increase in a packet of tube socks and then to massage those individual data points down to a single number.

Moreover, there is a weeks-long lag between the tallying the numbers and the government's announcement of the changes: The inflation measure comes out 12 times a year, though prices fluctuate, sometimes dramatically, all the time. Plus, the methodology is archaic, given that we live in the Internet age. Prices are easily available online and a lot of shopping happens on the Web rather than in stores.

In recent few months, economists have come up with new methods for calculating inflation at Internet speed - nimbler, cheaper, faster and perhaps even more accurate than Washington's. The first comes from the Massachusetts Institute of Technology. In 2007, economists Roberto Rigobon and Alberto Cavallo started tracking prices online and inputting them into a massive database. Then, last month, they unveiled the Billion Prices Project, an inflation measure based on 5 million items sold by 300 online retailers in 70 countries.

The BPP's inflation measure is markedly different from the government's. The economists average all the prices culled online, meaning the basket of goods is whatever you can buy on the Web. (Some items, like books, are most often bought online. Others, like cats, are not.) Plus, the researchers do not weight certain items' prices, even if they tend to make up a larger proportion of household spending.

Still, thus far, the BPP has tracked the CPI closely. And the online-based measure has additional advantages. It comes out daily, giving a better sense of inflation's direction. It also lets researchers examine minute, day-to-day price changes. For instance, this month Roberto Rigobon and Eduardo Cavallo noted that Black Friday discounts "had a smaller effect on average prices in 2010 than in 2009," contrary to reports of deeper discounting this year. And it has already produced some academic insights. For instance, Cavallo found that retailers change prices less often, but more, percentage-wise, than economists previously thought.

A second inflation measure comes from Web behemoth Google and is a pet project of the company's chief economist, Hal Varian. As reported by the Financial Times, earlier this year, Varian decided to use Google's vast database of Web prices to construct the "Google Price Index," a constantly updated measure of price changes and inflation. (The idea came to him when he was searching for a pepper grinder online.)

Google has not yet decided whether it will publish the price index, and has not released its methodology. But Varian said that his preliminary index tracked CPI closely, though it did show periods of deflation - the worrisome incidence of prices actually falling - where the CPI did not.

The new indices lead to the big question of whether the government needs to update its methods to account for changes in the economy - taking new pricing trends into consideration, rejiggering its formula, updating more frequently. The answer might be yes. (Economists have reformed CPI before.) But the CPI and its Stone Age method of calculation boasts one huge benefit: It's a stable, tested measure, consistent over time, because its methodology doesn't change much. Moreover, and somewhat remarkably, the Google and Billion Prices Project indices actually seem to confirm the accuracy of the old-fashioned CPI, tracking it closely rather than showing it to be off-base.

Ultimately, there is a good argument for more inflation measures, not just better or newer ones. The government calculates a number of rates of inflation to give a fuller picture of price changes, the value of money, and the economy. Most notably, the BLS publishes a "core inflation" number, a measure of inflation outside volatile food and energy prices. There are dozens of other measures, as well.

The new Web-based yardsticks provide even more alternatives and opportunities to examine the accuracy of the CPI - and to make new findings. That means, for now, those detective-like government workers painstakingly checking prices on clipboards get to stay on the job.

Lowrey reports on economics and business for Slate.

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