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## Finance and capital markets

### Course: Finance and capital markets>Unit 3

Lesson 1: Inflation basics

# CPI index

The consumer price index (CPI) is a measure used to calculation inflation. Learn about how the CPI is calculated, what it measures, and how it is used to track inflation in this video. Created by Sal Khan.

## Want to join the conversation?

• "sale of homes is the transfer of wealth from one generation to another" doesn't sound like moral or correct in our system. How can I understand this?
(6 votes)
• I think he means the process of people ageing, choosing to downsize, or going into care homes, etc and therefore cashing in their properties, and typically the buyer ends up being a younger person starting out on the property ladder. The inflation in homes prices, means higher housing prices, so the argument is it transfers wealth to the seller. I dont think there's a moral component at play.
(15 votes)
• What is impacted if inflation is understated?
(2 votes)
• The thing that is often impacted is consumer confidence.

Let's say you are a programmer analyst and earned a \$51,000 salary last year. The next year you receive a salary increase and received a salary of \$53,000; however, inflation increased to 8% from last year. If you do not realize that inflation increased, you might believe you actually received a salary raise and start spending it faster (consumer confidence)

However you are now actually receiving a lower salary than last year,
\$51,000 * .08 = 4,080 This number means how much your next year salary has to increase to EQUAL your last year salary.

51,000 + 4,080 = \$55,080
So \$55,080 next year is the same as \$51,000 last year.

Since the next year you only received \$53,000, you lost -2,080 from your last year salary.
53,000 - 55,080 = -2,080

In the end you ended earning less and believed that you had more money than last year :-(

By the way, 8% would be a HUGE inflation rate in the USA I only used it as an example (but it IS possible)
(14 votes)
• In this video Sal states that the CPI number should have been higher during the housing boom, but I think that number stayed artificially low because of the mortgage programs that people were signing up for. If you have a home and the borrower gets a mortgage for \$300,000 and the purchaser received a 30 year fixed mortgage at 5.5% his payment would be \$1,703. This is what you would have traditionally seen. However, with all the new programs that were available a borrower could have received an interest only mortgage on a home for \$400,000 and paid only \$1,833. A difference of only \$130 for a mortgage that is much larger. Wouldn't that continue to keep the CPI down artificially?
(2 votes)
• is cpi better than wpi to calculate inflation?
(2 votes)
• Wouldn't it be better the way it was represented instead of the "real" inflation numbers? Should't the understated versions of inflation have a positive impact on the people who bought homes at that time?
(2 votes)
• Do you have anything on the chained vs. unchained CPI?
(2 votes)
• I thought CPI didn't include housing costs?
(2 votes)
• When Sal was explaining the difference between renting and buying a home (Unit 2), I understood that he compared the 2 options using "how much money is paid out of pocket" each year. This is straightforward for calculating the amount in a renting situation, but in the buying situation, is it not the same idea as 'owners' equivalent rent'?
(2 votes)
• what does rent of primary residence mean in the housing section at ()
(2 votes)
• At what is meant with Governement or Corporate Liabilities?
(2 votes)
• One example of a government liability is a Social Security payment. One example of a corporate liability is a pension payment.
(1 vote)

## Video transcript

Everyone's talking about inflation and deflation these days, including myself, and that's because it's important. And in order to really have an informed view on it, I think it's important to actually look at how inflation is defined. And right here, I actually took a screenshot from my Bloomberg terminal, of the basket of goods that makes up the Consumer Price Index. The index that sets everything from the coupons on Treasury inflation-protected securities-- this is the index that dictates what Social Security payments are, how fast they're going to grow. I'm sure a bunch of union agreements and pension agreements are dependant on the CPI. So this is the underlying basket of goods that really tells us what inflation is. At a first level, it's just fun to look at, because you can compare your own household to what the government thinks is a typical household. For example, the government says that the typical household spends 15.7% of their disposable income on-- and that's essentially the income that you take home after paying taxes-- that they spend 15.7% on food and beverages. That seems reasonable. What's even more interesting is that they break it down. They get very granular. They try to figure out how much do you spend on eggs, and fish, and poultry, and bakery products. And that's good because, let's say, everything else stays constant, but the price of eggs goes through the roof because the Atkins diet becomes popular again. Then you can actually make an informed decision as to why inflation is going up or whether inflation will go up going forward. So that's just interesting to look at. If you look at the major categories. They have food and beverages, housing-- And I'm going to come back to housing because this is, in general, just a very interesting area to focus on, because it makes such a big portion of the CPI. And it's been such a big portion of the economic picture, especially the last 10 years. And obviously, it's become a big problem, has become a big factor, in terms of what's causing the financial crisis right now. But housing is about 43% of disposable income. Apparel: 3%. Transportation: 15%. This includes things like new vehicles, 4%, used cars and trucks. And I think the way they calculate this is, they say, what percentage of Americans are driving new vehicles versus used vehicles? And they put fuel in here. A lot of people, when I have this inflation-deflation argument, they make this argument that China and India are going to continue growing. And because of that, commodities like oil and fuel will continue to increase. Although people were making that argument more last summer, but even now people are making that argument. But in a developed country, you see that motor fuel, even though it hits your pocketbook on the margin, it isn't that big a part of your total expenditure. Especially when you compare it to things like housing. And if you keep going down, medical care: 6%. And then recreation. They break it down and you could look this up. I think the Bureau Of Labor Statistics has this broken down as well, although it was much easier to get it on the Bloomberg terminal. Education: on average, 3%. Obviously, if you're sending your kids to college that's a much higher number, but, on average, if you take the average household. And finally, other goods and services: tobacco, et cetera, et cetera. So that one is just interesting to look at. So whenever you have a discussion on the things that may or may not drive inflation, it's important to weigh them by these weightings that the CPI gives them, to figure out what the actual impact on how we measure inflation really will be. With that said, if you think about it, really the biggest portion of this is the housing piece. I think that's fair. Housing is a large percentage of most people's disposable income, especially in a Western society. You can imagine, if you live in a Third World country, and you're barely getting by, food might be a huge part of your expenditure, maybe rivaling housing if you've just kind of built a house someplace. But in a developed society, housing is a huge percentage of it. And I want to focus on one thing, and a lot of people have talked about this. And actually Mish once again, from Global Economic Analysis, he really encouraged me to highlight this. So within housing, obviously some people rent, some people buy. And so they give a 6% weighting of the whole basket to rent, and then they give a roughly 24%, 25% weighting to something that they call, owners' equivalent of rent of primary residence. So this is essentially their attempt to measure how much it costs to live for people who own houses. What's interesting, and you probably have caught onto it, is they use the words: owners' equivalent rent. So what they do, and this is the current methodology, they don't say, how much is your mortgage? They don't say, how much does it cost you to buy the house and amortize it over the reasonable life of the house? They actually just say, how much would it cost to rent that house? And they've kept waffling back and forth between-- sometimes they just look for equivalent houses, and they say, well, how much would that cost to rent? At one point they were actually surveying people and they would ask them, how much would it cost to rent your house? Which is probably even a worse number. But the bottom line is, they're not factoring in actual mortgages. And you can even see it on the weighting. Right when I looked at these numbers, I was like, well, roughly 66% of people own houses. How come this number isn't 66% relative to this number, right? It's closer to 80%. I was like, oh, I know that's fair because more people actually live in homes. You could say that 66% of overall households own, but, in general, homes are bigger, there might be more people in it. So you could either think of it on a person basis or maybe on a square footage basis. It makes a little bit more sense to weight houses higher. But what's interesting here, is that this number, especially if you add these two, housing in general is about 30% of disposable income. And traditionally that was the rule that a bank would use to decide whether you can afford a house. It shouldn't be more than a third of your disposal income, or at least a mortgage payment shouldn't be more than a third. We know, especially over this last real estate bubble, that's become a much, much larger percentage of people's actual disposal income. So you wonder, why is this weighting only 30% of disposable income? Well, that's because they use owners' equivalent rent. They didn't actually say what people's mortgage payments are. So even though mortgage payments might be going through the roof, even though the price of a house might be going through the roof, it does not get reflected in the CPI number as of the early `80s. This is straight from the Bureau Of Labor Statistics website. And they wrote-- and they're actually using doublespeak here, I just copied and pasted it straight from their website --"until the early 1980s, the CPI used what is called the asset price method to measure the change in the cost of owner-occupied housing." That makes sense and I'm not sure whether they just looked at how much houses cost this year relative to last year and then they put that into the weighting or they determined the weighting based on people's average mortgage. But in general, that's a good way to measure it, right? Either your mortgage payment, or how much houses cost. They said, "the asset price method treats the purchase of an asset, such as a house, as it does the purchase of any consumer good." Fair enough. "Because the asset price method can lead to inappropriate results--" And this is the key line. "Because the asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons." I agree with that. If something is purchased largely for investment reasons, if I'm purchasing gold, maybe that shouldn't be included in the CPI, because it's largely for investment reasons or for stocks. But then they use this kind of completely disjointed logic. They say, you know, "because asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons, the CPI implemented the rental equivalence approach to measuring price change for owner-occupied housing." To me, that makes no sense. Owner-occupied is not purchased for investment reasons. That's a fair enough argument if you're doing it for rentals, or if you're doing it for vacation homes. But for actual owner-occupied housing, this sentence makes no sense. Based on their own rationale, there's no reason to transfer to this rental equivalent approach. The whole reason why I'm going here is, because in the early `80s, I think 1983-- they say it right here, in January, 1983-- because they switched over to this, this kind of inflation that we've seen in the price of houses, especially the real estate bubble we've seen the last 10 years, in no way got incorporated into the inflation numbers. So it essentially understated them. You can see that here. Well, two things: not only did it understate it, but it probably understated the weighting itself. And Mish, he's had a couple of posts about this. You really should use something like the Case-Shiller Index on this line right here, instead of doing this for owners' equivalent. But I'd argue one step further. Not only should you use something like the Case-Shiller Index, but to actually gauge this weighting, you should actually survey people and say, what percentage of your disposable income is dedicated to your mortgage and other things related to owning a house? And especially over the last seven years, I would guess, and I'm almost sure about this, that it would be much larger than 30% of your disposal income. So not only was this number being understated, or the growth in that number, because it didn't incorporate the increase in housing prices, but this weighting itself was understated. And just to get a sense of how much, this is the Case-Shiller Index. And you could look up the Case-Shiller Index, but, in my opinion, it's the best index for actual increases or decreases in the price of homes. You see from 2001 to 2006 roughly, houses were increasing by 10% to 15% a year. So if you use that instead of the rental equivalent, then over the same timeframe-- I don't have a chart for rent, but rent was not increasing at anywhere near this pace. If anything, people were leaving apartments to buy houses, so rent was actually staying pretty stable. But 10% to 15%-- this is year over year growth, this is what this chart is. So 10% to 15%, if you weight that at 30% of the CPI basket, then really the reported inflation number was being understated by 3% to 5% a year. And I'd argue that this weighting should have grown over that time period because people were spending more and more of their disposable income on their mortgage payments. So really it was probably understanding it by more. Then this weighting should've been more like 40% and you could have said you're understanding it by 4% to 6%. And if you look here, this is the actual reported CPI numbers. What I'm saying is, over that timeframe, the real inflation number should have been up here. And then, now that we have actual deflation in home prices, this is zero. So now, the most recent Case-Shiller numbers say that housing has depreciated by 20%. We're essentially understating the deflation now. So although right now the CPI has us at kind of the zero mark, if you actually incorporated the real prices of homes and you didn't use rents as a proxy for it, you would actually get a much more negative number here. And Mish actually did that on his blog. And if you actually want to read his blog, which I highly recommend, do a Google search for Mish, M-I-S-H. And this is directly from his blog, so I have to give him credit for that. And what he did here is, he actually charted the actual inflation numbers that were reported. That's in blue. And then on top of that, he put what he calls the Case-Shiller CPI Index and that's in red. And you see here, especially over the housing boom-- These are the inflation numbers we got from the government. They peaked out in the 4% or 5% range, which isn't low by any stretch of the imagination, and that's probably why the Feds started increasing interest rates right around here, arguably at the worst possible time. But if you look at the CS CPI, or the Case-Shiller CPI, you could almost say that the real inflation actually peaked out in the 8% range back here. And you could argue that, if this was the actual number that the Fed was using, it would have actually been a much better policy tool, because they would have seen the inflation pop up back here in January '03. And they would have known that they were keeping their monetary policy too loose back here and they could've avoided this whipsawing that they did and in 2007 and 2008. And I'd argue even further that even this number is understanding the reality, because back here, as a percentage of the actual CPI basket, he just took the CPI numbers and replaced the year over year change essentially into the same weighting as the current CPI numbers. But if you actually weighted it based on the actual amount of disposable income people were spending on their mortgages, I would guess that it would have looked something more like this. And you would have seen actual inflation peak out here, probably in the 10% or 11% range. There's a lot of social commentary about this; why they do it. One argument is, that a lot of the government's or even corporate liabilities are indexed to inflation. You have an inflation index. On the other hand, the sale of homes essentially transfers wealth from one generation to another. Especially when you have a huge increase in the price of homes. If they did this on purpose, and I'm guessing that they did, it allows housing prices to increase dramatically. And when housing prices increase dramatically, it transfers wealth from the new buyer generation to the retiree generation, so it helps subsidize the retirees. And, at the same time, by taking it out of the actual CPI index, it keeps the government's, and actually a lot of other corporate, liabilities low. Because now Social Security, it's indexed to the CPI numbers. So if the CPI numbers are not incorporating, are not raising up here, you don't have to increase people's Social Security payments. And you kind of get to project this farce to people. You say, oh, in inflation adjusted terms, you're doing better than your parents' generation did. Oh, but, by the way, you can afford 1/3 the house now. And to some degree that's been propagated-- it's obviously all falling apart now. But the big takeaway from this, if I had to give you just one, is that the CPI index is a government created tool. It's based on a survey and, not only has it not been the same survey, but it's actively changed over the years. And it's changed in ways that significantly impact the actual numbers that are reported and, to some degree, play into what I think the government wants people to believe. Anyway see you in the next video.