Statistics are like bikinis...

Statistics are like bikinis. What they reveal is suggestive, but what they conceal is vital. (Aaron Levenstein)

Average pub discussions over the past 20 years have probably involved the odd commentary on how the price of a pint has changed over that time. "A lot" would typically be the consensus opinion; and that opinion would be correct. The Good Pub Guide celebrated its 25th anniversary in 2007 and as part of the celebrations managed to convince a series of pubs to sell pints on the 28th of September 2007 at the same price as they were selling in 1982. The Drunken Duck in Hawkshead, Cumbria for example were selling pints of "Cracker Ale" (named after the pub dog from 1982) from their own micro-Brewery for only 62p. 2007 prices were £2.65 for the same. That represents inflation of 427% over that time. Needless to say a lot of the increase is due to tax increases justified by a greater awareness that Guinness is not as good for you as the old adverts would have suggested. Nevertheless, inflation was unquestionably substantial.

Elsewhere in the world of the man on the Clapham omnibus, or in current parlance an individual from the "real economy" there is plenty of anecdotal evidence of substantial price inflation across our monthly regular purchases, over whatever time horizon you might choose. In 1982 the price of a gallon of petrol was £1.59 (35p/ litre) and the average house price was £23,644. 25 years on in 2007 as the Good Pub Guide celebrated their 25 year anniversary those figures were just over £5/ gallon (111p/ litre) and average house prices were just shy of £200,000. Those are price increases of 214% and 747% respectively. The latter in particular would form the bulk of monthly outgoings, through mortgage payments, for the average home owning Brit. For those across the pond the average house price in the USA in 1982 was just over $82,000. In March 2007 it was $324,000. A 295% increase.

The centerpiece of economic policy in the UK, the USA and many other countries over the past 20 years has been clearly stated as targeting of inflation, through rigid observance of monetarist economic policies. The UK ceded control over interest rates in 1997 by making the Bank of England independent and in theory removed from political decision making. Their strict and only charge was responsibility for keeping inflation below it's target rate (below 2%), through monetary policy and interest rate management. The gist here is that if prices are kept stable then it makes it easier for individuals and businesses to make sounder, more long term decisions about savings and investment.

So given that statistics about inflation directly affected (in fact were the only thing that affected) the rate of interest set by the Bank of England it might be fair to say that the accuracy of that statistic was fairly important. The same is true in the US, and in the European Union, albeit that both the Federal Reserve and the ECB have a slightly wider mandate than just inflation targeting.

Consequently if inflation calculations failed to truly recognise properly the extent of inflation in the "real economy" we might end up in a situation where interest rates were not at the right level, and money supply would be out of whack with what was required to the right balance between savings and investment.

According to the Bank of England and the IMF inflation in the UK between 1982-2007 was 112%, based on the Consumer Price Index. In the US according to the IMF that figure was 114%. "Hang on a second" - you might reasonably say, "the cost of my house and the price that i pay for petrol have risen by loads more than that during that period...and they are pretty important aspects of my monthly outgoings".

So how do the central bankers get their inflation figures?
It depends on the "market basket" which is chosen. In the United States, the price of food, fuel and purchasing a home are excluded from the "core" inflation rate. That is why the price of food, fuel and buying a home can rise so rapidly without being reflected in the official "rate of inflation". Which seems fairly ridiculous, as the value of your home plays a pretty key role in your approach to discretionary purchases and the amount of credit that a bank might lend you to make those discretionary purchases.

In China the price of food is included, so they started showing a sharp rise in inflation as soon as food prices started rising. In India the price of fuel is subsidized by the government, as is wheat too. So that makes things appear different than they actually are. Somebody is paying the real price somewhere. In the case of imported oil, that has been a hefty bill, which is why upward adjustments are being made now.

Perhaps most disturbingly, if you look into the details of how the Bureau of Labor Statistics (BLS - or potentially just BS) calculates its CPI figures for the USA there has been clear political manipulation over the past 20 years pushing this office to portray the US economy as strong and inflation free. As a case in point, during the early 1990s during the Clinton era there were significant budgetary issues with the rising costs of Social Security, Medicare and government pension provisions - the cost of which was indexed off CPI. Perhaps it's cynical to connect these to the changes in inflation calculations that followed, but it's clear that they had the effect of reducing that CPI figure considerably, and consequently the outgoings from the Treasury.

Three main changes were made to CPI calculations: 1) hedonic quality adjustments, 2) calculations of housing costs via owners equivalent rent and 3) geometric weighting/ product substitution. Running through these - Hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durable goods - a dubious assumption belied by the experience; as your new model MAC or PC was going up by a hundred dollars or so it was actually going down according to CPI calculations because it was twice as powerful. As regards 2) it was claimed that a measure of housing base on what an owner might get for renting his house would more accurately reflect the real world - dubious again. The average cost of homes has appreciated 3 times the annual pace of substituted owners equivalent rent, which would have raised the total CPI by around 1% had the change not been made. Regarding the third change, product substitution and geometric weighting both presumed that more expensive goods and services would be used less and substituted with their less costly alternatives: more hamburgers/ less filet mignon when beef prices were higher etc. Proven untrue also.

As a consequence of these changes some estimates suggest that the inflation figures used by the US government and the Federal Reserve may have been 3-4% too low. Some might say, well what difference does it make. IT MAKES A MASSIVE DIFFERENCE.

The correct measure of inflation matters in many areas, not least in the calculation of social security payments and wage bargaining adjustments. The number is also critical in any estimation of bond yields, stock prices, and commercial real estate cap rates. It seems pretty evident now that interest rates in the US/ UK were way too low based on the real evidence about inflation. Credit expansion of close to $23 trillion between 2000-2008 in the US was driven by a complete imbalance between the relative costs of savings and investment. Most of that credit was "created" or "asset backed" by rising property prices, which as i've explored above were completely misrepresented in terms of the inflation figures being published. Manipulation is less obvious in the UK, but the "basket" calculation still unrepresents hugely the housing boom which we've seen in the last 15 years, and on which much of the credit expansion has been based.

If people are looking for places to point a finger of blame, the statistics would be a good place to start. 98% of statistics are made up apparently.