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Inflation Is So Much Worse Than We're Told

Tuesday, January 25, 2011, 11:00 AM

Inflation is actually much higher than what the BLS claims it is; something that purchasers of college tuition, pharmaceuticals, or health insurance know all too well.

To give the BLS some credit, they must try and estimate a single rate of inflation that applies to everyone equally.  But that is a completely impossible task. An octogenarian living in Seattle on a meager pension and taking lots of prescription medications will have a totally different inflation experience than an 18 year old living in their parent's basement eating Ramen noodles. 

But even after spotting the BLS some slack, there are some enormous and glaring errors in their methods that render the official inflation measure hopelessly - and dangerously - inaccurate. 

In this article, I am going to reveal how US inflation numbers are badly understated, how this practice short-changes institutions and fixed-income individuals alike, and why this means fiscal and inflationary train-wrecks are the most probable outcome for the US -- and, by extension, the globe.

Why This is Important

As a refresher, inflation in the US is calculated by the Bureau of Labor Statistics (BLS) in a measure called the Consumer Price Index, or CPI. It is used by the Federal Reserve to justify its money printing policies, by the federal government to calculate cost-of-living adjustments (COLA) for the entitlement programs (e.g., Social Security), and to set the interest rate on inflation-adjusted bonds known as TIPS. Indirectly, the CPI influences interest rates, the stock market, and a host of salary and pension negotiations each year. If the CPI is too low, even by a single percent, the impact is in hundreds of billions of dollars.

And from a financial planning standpoint, the impact is just as dire. If you are putting away money for a child for college, the rate of inflation you apply to the tuition has an enormous impact on the amounts you'd need to put away. In eighteen years, a current $40,000/yr tuition will become $66,000/yr at a 3% rate of inflation, but $107,000/yr at a 6% rate of inflation. The same logic and results apply to retirement planning.

Further, the cost estimates surrounding the current health-care debate in the US are founded on inflation projections that draw upon prior CPI readings for their baselines.

It is vitally important that our assessment of inflation be as accurate as possible.

Unfortunately, the CPI understates inflation, which is much higher (worse) than we're told.

Understanding exactly how this is accomplished will help clear your mind and lead to more certainty in your decisions.

Caveat Emptor

Every country fights its last battle, and in the US, unlike Europe, the prior enemy was deflation, which ravaged the land in the 1930's. 

Seeking to avoid that fate repeating itself, the US Federal Reserve routinely justifies the continuation of its massive money printing experiment (which goes by the all-too-fancy title "Quantitative Easing") by citing an apparently low rate of inflation, as provided by the BLS.  

Here's a recent example of such justification at work:

Recent data show consumer price inflation continuing to trend downward. For the 12 months ending in November (…) inflation excluding the relatively volatile food and energy components--which tends to be a better gauge of underlying inflation trends--was only 0.8 percent, down from 1.7 percent a year earlier and from about 2-1/2 percent in 2007, the year before the recession began.

(Source)

A 0.8% yearly rate of inflation (ex food and energy, of course) that is trending downwards certainly makes inflation sound like a non-issue and supports the idea of dangerous deflation lurking nearby. 

Indeed, the Fed is right, after subtracting out the items that are most responsible for keeping everybody alive and comfortable (food and energy), the rate of inflation as reported by the BLS seems to be locked in a mortal tailspin…as long as you only look at the narrow range marked by the red line below:

(Source)

Well, the average person would be well within their rights to wonder what all the fuss is even about. After all, inflation is now within 0.06% of its ten-year average, and unless you are calculating the trajectory of a newly launched Mars probe, 0.06% is not really that big of a deal. But the Fed is terrified of it.

Backing up this view is the BLS, which provided us with these data for December 2010:

(Source)

According to the BLS, the average household experienced an exceedingly tame rate of inflation of only 1.5% between December 2009 and December 2010. That is, what used to take $100 to buy in 2009 requires $101.50 in 2010; only a dollar-fifty more. Once we strip out food and energy, the cost index plummets, requiring only 80 cents more than a year ago to buy the same basket of goods and services.

The only problem with this view is that it is utterly, provably, and demonstrably wrong.

I can reveal how with one relatively simple example.

[Note to any journalists reading this. My standing offer to you is this: I will spend as much time as you wish going through this data if you feel that understanding it more completely will help your current or future reporting on the issue.]

Health Insurance and the CPI

As I mentioned in the Crash Course chapter on inflation, there are three major statistical 'tricks' that the BLS imposes on the Consumer Price Index. They are hedonics, which tries to account for improving quality in products over time, substitution, which is the act of switching to lower-cost items when prices surge on preferred items, and weighting.  

For less-than satisfactory reasons, the BLS only weights healthcare at 6.5% of the CPI, although it represents 17.6% of the total GDP. That's a big problem, because healthcare is the biggest and most consistent source of inflation over the years.

[Note:  This next section has been extensively edited from its original content to reflect new understandings and information.  See comments below for the context for these changes. Briefly, based on a conversation with a BLS employee I had incorrectly assumed that 'health insurance' reflected the total cost of health insurance.  It does not.  It is only meant to reflect changes in the retained earnings ratio of health insurance companies.  I truly dislike making errors and seek to correct them publicly and completely whenever they occur.]  

Medical care as a CPI component rather oddly excludes all government expenditures for healthcare (primarily Medicare and Medicaid) and does not count the rising costs of health insurance to businesses.  After subtracting out these expenditures only 6.5% remains from the 17.6%. 

(Source)

It turns out that in its attempt to capture health insurance the BLS splits it into two cost streams, one which goes towards paying for health care and the other which goes to the insurance companies.  The first cost stream is allocated to the medical care components listed above while the insurance company component is contained within the 'health insurance' subcategory.   But it's all done by what is described as an 'indirect method.'

Here's the official explanation 

The weights in the CPI do not include employer-paid health insurance premiums or tax-funded health care such as Medicare Part A and Medicaid. Currently, the index employs an indirect method for measuring price changes for health insurance premiums.

Under this indirect method, the medical care index will not be affected by changes in policy characteristics, such as modifications to policy benefits and utilization changes. The approach implicitly assumes that the level of service from individual carriers is strictly a function of benefits paid.

(Source)

By this method, the rising costs of medical care should feed into rising health insurance costs, which will then be captured in the medical care CPI.   Also, we might note that the part in bold implies that changes to insurance policies such as rising deductibles and copays, both very significant portions of the current experience for most people, will, perversely, cause the CPI for medical care to drop because less money will be registered as going towards medical services and commodities.  You pay the same amount to the health care company for insurance, but less is paid out because you have to shoulder a bigger portion via deductibles and co-pays and, presto!, less money is recorded as being paid out and so inflation is apparently less. I still need to vet that thought process with the BLS to be sure I've got it right, but the way things are worded, that's the only way I can interpret it.  

The cost of health insurance itself, has apparently been steadily falling for the past three years something that will be news to anyone whose premium's have vaulted up:

(Source)

Because most private health costs are paid by insurance claims, it stands to reason that the medical care CPI should track the rise in health insurance over the years.  That is, if the methodology for tracking health insurance costs works, and those costs are properly allocated into the CPI, then both should give roughly the same answer over time.  

But they do not.

Where the CPI for medical care purports a 52% increase over the 1999 - 2009 time period, health insurance premiums have risen by 131%:

In just those two errors, underweighting healthcare and the inexplicable gap between health insurance increases and the medical care CPI, by my calculations the BLS is understating inflation by at least three percent, and possibly more. 

[end of modified content]

If three percent does not strike you as a lot, go back and re-read the example about college tuition I provided in the sixth paragraph of this article.

Conclusion (to Part I)

For the reasons above, inflation is much higher than proclaimed. Yet we are being told, on a near-daily basis, that the massive money printing and deficit spending activities of the Federal Reserve and federal government, respectively, are not stoking inflation. At least, 'not yet.' Since the Fed uses the CPI as a key indicator in its decision making, the big risk here is that Bernanke will not begin to turn the wheel on the monetary supertanker until after it is too late. 

Anybody engaging in any form of long-term financial planning - be they individuals, pension trustees, or budget setters - needs to be aware of the flaws and limitations of the official US inflation measure.

All COLA increases based on the CPI are too low. Any health care policy analyses that rely on the CPI (which is most) will vastly underestimate the true costs and are doomed to trap the nation in a regime of rapidly rising costs and deficits.

We are risking much by systematically understating inflation including our reputation, market confidence, and even the dollar itself. 

Part II of this report digs much more deeply into this material and - important for both for individual and professional investors - lays out my predicted scenario for how this will all result in a systemic financial breakdown. Assets classes for inflation protection are also discussed.

Related content

26 Comments

Tim_P's picture
Tim_P
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Re: Inflation Is So Much Worse Than We're Told

Is it possible that the insurance cost is trying to reflect the actual cost of insurance as opposed to the cost of the insurance and medical care combined?  For instance, if you send $100 to an insurance company and that company uses $80 of that to pay medical claims (not necessarily yours), does the insurance cost $100 or does it cost $20?  If the $80 is used to pool money for medical claim reimbursement, is that truely the cost of insurance or is that the medical cost channeled through the insurance? 

I'm not saying it is, or that it is not, but simply putting up one possible justification for the unrealistically low insurance component.

Tim

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Re: Inflation Is So Much Worse Than We're Told

It's even worse than Chris suggests. Have a look at this excellent article. The others on this website are also very interesting.

http://www.howitends.co.uk/the-rate-of-inflation.php

Poet's picture
Poet
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Sh*tfilled Fantasy World

We're living in a sh*tfilled fantasy world, seriously, if everyone (from retirement planners to government bureaucrats to business planners to contract negotiators) is using the same bullsh*t numbers.

And especially outrageous, yes, that health insurance, which typically costs about $13,000 to $15,000 per year (shared by employer and employee) to cover a family, is somehow less than 0.5% of CPI though it's actual rate of increase is 3 to 4 times the CPI number.

Doesn't this mean the looming Medicare/Medicaid unfunded liability isn't $75+ trillion, but much, much higher?

"The Ben Bernank" is eating sh*t and spreading crack.

Thanks so much for warning us about the piles of doo-doo out there, Dr. Chris. Unfortunately I think this country is gonna roll in it anyway.

Poet

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DurangoKid
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Re: Inflation Is So Much Worse Than We're Told

The Party announces the ration of bully beef has increased and everyone cheers.  Only problem is that the ration has gotten smaller, but no one seems to notice.  Those who do notice know it's best to keep quiet about it.

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Re: Inflation Is So Much Worse Than We're Told

Long-time listener. First-time caller.

I had the same thought as Tim_P - that the insurance category was probably overhead or insurance company profit, etc. Indeed, this appears to be the case, as explained by the BLS here:

http://www.bls.gov/cpi/cpifact4.htm

Under the "Health Insurance" section, it is explained that, "the weights for most of MCS [medical care services] indexes reflect out-of-pocket expenditures plus allocated health insurance benefit payments." So, the portion of our insurance premiums that is used to reimburse health care providers is not included in the 0.487%.

This appears to be an honest misunderstanding on Chris' part.

Bill Bishop

Poet's picture
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Re: Inflation Is So Much Worse Than We're Told

Stoicsmile wrote:

Long-time listener. First-time caller.

I had the same thought as Tim_P - that the insurance category was probably overhead or insurance company profit, etc. Indeed, this appears to be the case, as explained by the BLS here:

http://www.bls.gov/cpi/cpifact4.htm

Under the "Health Insurance" section, it is explained that, "the weights for most of MCS [medical care services] indexes reflect out-of-pocket expenditures plus allocated health insurance benefit payments." So, the portion of our insurance premiums that is used to reimburse health care providers is not included in the 0.487%.

This appears to be an honest misunderstanding on Chris' part.

Bill Bishop

Question: Since health insurance premiums are still a cost to us the consumer and is definitely a big part of our income, where DOES that get counted in the CPI, then, if not under health insurance?

Poet

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Re: Inflation Is So Much Worse Than We're Told

Question: Since health insurance premiums are still a cost to us the consumer and is definitely a big part of our income, where DOES that get counted in the CPI, then, if not under health insurance?

Poet,

The sentence previous to the one I quoted is, "The CPI allocates [changes in the prices of medical care items covered by health insurance policies] to the indexes that account for medical care items (i.e. physicians' services)." So, a portion (probably a large portion) of each of the medical care items that are listed (together totaling 6.513% of the CPI) is for insurance premiums.

Bill

Tim_P's picture
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Re: Inflation Is So Much Worse Than We're Told

Stoicsmile wrote:

Long-time listener. First-time caller.

I had the same thought as Tim_P - that the insurance category was probably overhead or insurance company profit, etc. Indeed, this appears to be the case, as explained by the BLS here:

http://www.bls.gov/cpi/cpifact4.htm

Under the "Health Insurance" section, it is explained that, "the weights for most of MCS [medical care services] indexes reflect out-of-pocket expenditures plus allocated health insurance benefit payments." So, the portion of our insurance premiums that is used to reimburse health care providers is not included in the 0.487%.

This appears to be an honest misunderstanding on Chris' part.

Bill Bishop

That also helps to explain why the insurance number is getting smaller then.  It's not that it's getting cheaper, but that the margin is getting thinner.

Tim

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Re: Inflation Is So Much Worse Than We're Told

@Tim P/Stoicsmile

I think, given what we know about the real margins of healthcare companies (about 2%) that this gross margin of about 7.5% makes sense. ($239 is 7.5% of $3200, $3200 = .06513*$49077)  It's not entirely accurate because of OOP costs that are included (not all of that 6.513% goes to health insurers), but its close.

That said, this $3200 creates a monthly premium of $266 (again, assuming no OOP costs - which isn't fair, but we'll assume it).  But the Kaiser Foundation declares the following: The average annual premiums in 2010 are $5,049 for single coverage and $13,770 for family coverage. Compared to 2009, the average premiums are about 5% and 3% higher for single and family coverage, respectively.

So, even if we're lying to ourselves, by saying that whole $3200 is for health insurers, Kaiser's telling us we're still off by a factor of 2 or 4 (single/family) [Source: http://ehbs.kff.org/?page=charts&id=1&sn=6&ch=1500 ]

So while Chris may have erred in conflating margin for Health Insurance costs (which, if you're right, aren't indpendently reflected, because they're subsumed in the other numbers), his general point that the BLS is lying about the Healthcare data is still spot on - just not to the magnitude he declared.

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Re: Inflation Is So Much Worse Than We're Told

Will we all be eating dog food soon?   Substitute sequence: Steak -> Ground Beef -> Dog Food

Poet's picture
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Health Insurance in CPI

I want to thank everyone for their input and explanations.

I think we should also wait for a response from Dr. Chris.

Poet

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Re: Inflation Is So Much Worse Than We're Told

Thanks for the info

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Re: Inflation Is So Much Worse Than We're Told

The 6.5% figure for "consumer" health costs seems reasonable if the total is 17% of GDP.  Much of the total healthcare bill is paid for by government (Medicare and Medicaid) and a large part is covered by employers. This is saying about 1/3 is covered by consumers on average including all households (including those on medicare and medicaid).

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Re: Inflation Is So Much Worse Than We're Told

wfhyslop wrote:

The 6.5% figure for "consumer" health costs seems reasonable if the total is 17% of GDP.  Much of the total healthcare bill is paid for by government (Medicare and Medicaid) and a large part is covered by employers. This is saying about 1/3 is covered by consumers on average including all households (including those on medicare and medicaid).

The BLS explains as much (at the link I sent previously). "The weights in the CPI do not include employer-paid health insurance premiums or tax-funded health care such as Medicare Part A and Medicaid."

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Re: Inflation Is So Much Worse Than We're Told

Stoicsmile wrote:

Question: Since health insurance premiums are still a cost to us the consumer and is definitely a big part of our income, where DOES that get counted in the CPI, then, if not under health insurance?

Poet,

The sentence previous to the one I quoted is, "The CPI allocates [changes in the prices of medical care items covered by health insurance policies] to the indexes that account for medical care items (i.e. physicians' services)." So, a portion (probably a large portion) of each of the medical care items that are listed (together totaling 6.513% of the CPI) is for insurance premiums.

Bill

Bill,

thank you for bringing this clarification to the discussion - you (and Tim) are quite right, the BLS spreads (allocates) the health insurance premiums across the medical care buckets (services and commodities).  I am delighted to have the chance to advance this discussion, but disappointed that I did not wait to hear back from the BLS to gain this insight before publishing this piece.  That's a big 'oops' on my part and I take full responsibility for racing ahead too quickly.

However, now that we're here, I have gained enough additional insight to modify the tale while not changing the major conclusion that health care is woefully underrepresented in the CPI and drags down the inflation reading as a consequence.

Here's the major point, if we consider Medical Care to be the major bucket of expenditures, and everything is lumped in there, but allocated here and there, then everything should be in there.  Health Insurance is in there, as are out of pocket expenses, and everything else.

Since health insurance is the main method by which consumers pay for health care, then there should be good alignment over time between the Medical Cost inflation contained within the CPI and health insurance premiums.

But there isn't.  If we take a full yen year series (1999 - 2009, latest data available for HC insurance), baseline both series to 100 in 1999, here's what we see (note that the insurance data is yearly so it looks like a staircase, while the CPI data is monthly and therefore appears smoother):

Now, as your link to the BLS pointed out, the BLS purports to allocate the entire impact of rising health insurance to the Medical Care subcategories, which means that there should be some alignment between the two.  

Clearly, there is not.  For a family paying for health insurance privately, the CPI claims their medical care costs have risen by 52% between 1999 and 2009, while their health care premiums will have risen by 131% over the same period.  For those with employer provided health care the story is the same but the portion picked up by the employer is hidden from the CPI's view because that is not counted.

Something in the BLS methodology is badly missing the rising costs of health insurance and it's quite a profound difference.

To my main point, namely that the official inflation measure of the land ought to capture inflation, I find the exclusion of government expenditures and business costs to be unacceptable.  That's something I stand behind.  

Otherwise, because they are excluded, as long as we placed 100% of healthcare spend into government or business hands we'd never again experience any reportable inflation in health care; clearly a preposterous notion.  Government subsidies are one of the most sure-fire ways known to distort prices and stoke inflation (see also: college tuition).

There aren't that many satisfactory explanations for the persistent and  rising gap between health insurance costs and the purported medical care CPI; one is that the CPI measures of inflation are far too low and the other is that insurance companies are taking in far more money than the BLS allocates across the CPI.  My best guess is that it's a bit of both, but weighted towards the CPI being too low.

In support of which, I might note that the most persistent claim made before state regulatory bodies by health insurance companies for rate hikes involve claims of rising health care costs that are far, far higher than the 3.5% rise in the 2010 medical care CPI:

WellPoint Inc.’s request to raise rates as much as 28 percent on small-business health plans in New York will face increased scrutiny because of new U.S. regulations, the state’s top health-insurance official said

About 15 percent is “entirely driven by increasing medical costs for small employers in New York,” said Kristin Binns, a WellPoint spokeswoman, in the e-mail.

(Source)

Either way, whether the CPI is too low or health insurers are taking too much, this analysis tells me that the CPI for medical care is woefully undercounting the impact and pace of inflation in this area.

I am going to edit the main article for accuracy, while preserving the original content as much as possible and making the edits crystal clear so that nobody will accuse me of trying to cover anything up.

I like to let the data tell me the story, and when I find out more, I will always adapt my thinking and words to reflect the new data and understandings.

SingleSpeak's picture
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Re: Inflation Is So Much Worse Than We're Told

We may need Columbo to find where all of the dead bodies are buried, but between Chris and the hoard of CM fact-checkers that are doing this in-depth investigating, it is clear that the numbers are conveniently massaged in the government's favor. 

Side note-

Chris said, "...I will spend as much time as you wish...."

You may want to include a caveat in this type of offer in the future, like " I will spend as much time as you wish, within reason".  Otherwise, in the unlikely event that a journalist should take you up on your generous offer, you could be tied up for days, weeks, or months, and the social unrest on this site would get ugly.Wink

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Re: Inflation Is So Much Worse Than We're Told

Thanks Chris.  I have no doubt that inflation is under reported, but simply thought that one item might have been misread.  I appreciate the update.

Tim

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Re: Inflation Is So Much Worse Than We're Told

Will we all be eating dog food soon?   Substitute sequence: Steak -> Ground Beef -> Dog Food

Steak -> Ground Beef -> Dog Food -> Soylent Green.

"It's people!...It's people!

Mmmmmm...Bernanke taste delicious

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Re: Inflation Is So Much Worse Than We're Told

Chris,

Glad I could contribute to the discussion. I don't know much at all about how the economy works or where we're headed, which is one of the reasons I frequent this site. As a mechanical engineer, I have a much more intuitive sense of the Energy and Environment portions of the three "E"s. I look forward to reading more of your thoughtful, detailed analyses of the issues, and I appreciate the service you provide, even to those of us in the cheap seats.

Thanks,

Bill

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Re: Inflation Is So Much Worse Than We're Told

I know the CPI is reported without food and energy ... but why?  It that the usual way it's reported?  It seems that food and energy takes up an increasingly larger and larger chunk of our paychecks so it should be reported in the CPI, right?

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Re: Inflation Is So Much Worse Than We're Told

Mr. Fri wrote:

I know the CPI is reported without food and energy ... but why?  It that the usual way it's reported?  It seems that food and energy takes up an increasingly larger and larger chunk of our paychecks so it should be reported in the CPI, right?

<sarcasm>That would not be appropriate, because these prices are "volatile". As in, we all know we could extract more oil than we could ever use for the next 200 years right here in America, so the price will soon crash to the low 20s. Besides, we all know that imported food from China and Asia in general is just getting cheaper and cheaper, for us Americans anyway, they eat the inflation abroad, so it will make it all cheaper for us in the future!</sarcasm>

Samuel

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Re: Inflation Is So Much Worse Than We're Told

Mr. Fri

The CPI does include food and energy.  Then they subtract those numbers and the result is the "core inflation rate", because food and energy can be volitile The media dutifully reports this lower "headline number".  I don't know why.  Maybe because the BLS tells them this number is more useful.  Maybe because they are just parrots.  It is a ploy to make inflation look better than it is.  I have yet to find a way to subtract food and energy from my bills.  How about you?

Travlin 

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SingleSpeak
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Re: Inflation Is So Much Worse Than We're Told

I'll try to simplify the reasoning for currently accepted accounting methods used by BLS.

Core inflation - "The ship seems to be floating along pretty well."

CPI using hedonics, substitution, and weighting (for better accuracy Wink) - "The ship is barely taking on water."

CPI in real terms (eliminating accounting tricks) - "We're sunk."

This is why "core inflation" is what we need to pay attention to.

SS

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Re: Inflation Is So Much Worse Than We're Told

BOE's Mervyn King acknowledging the obvious.

http://www.telegraph.co.uk/finance/economics/8282354/Bank-of-England-chief-Mervyn-King-standard-of-living-to-plunge-at-fastest-rate-since-1920s.html

By the way, if stagflation is no growth and inflation, what do you call negative growth and inflation?

TimesAwasting's picture
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Re: Inflation Is So Much Worse Than We're Told

NegraflationTongue out

A1B2C3D4's picture
A1B2C3D4
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So what are we to do to stop the madness?

The administration, whether Democrat or Republican, would not have been able to get away with murder if the American people were truly educated.

Conclusion is that the electorate is profoundly ignorant to begin with. On top of that we have the mentality of the government union types who consider themselves to be entitled to the exorbitant benefits they have at taxpayer expense.

Solution requires that enough of us do some reading. Since the subject of this thread is inflation and by implication the role of the central bank in America, i strongly recommend a book by G. Edward Griffin entitled The Creature From Jekyll Island. 

It is all about the creation of the Federal Reserve System in 1913. 

In addition Murray Rothbard's The Case Against The Fed  and Ron Paul's End The Fed are instructive.

Alan Greenspan's article on Gold in Ayn Rand's Capitalism: The Unknown Ideal is also enlightening.

The movie version of Atlas Shrugged will be a trilogy and part one is coming to theaters on April 15th. Google Atlas Shrugged movie to find the trailer.

Better still read the book. 

Then join www.campaignforliberty.com and www.YALiberty.com

Enjoy!

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