Oct. 6 (Bloomberg) -- Bill Gross, the highly regarded chief investment officer for Pacific Investment Management Co., last week called the notion that the U.S. has a low level of inflation a ``con job'' foisted on ``a gullible public'' by the federal government and the Federal Reserve.

Gross may run the world's biggest bond fund, but his column amounted to an inaccurate and analytically flawed diatribe.

He virtually accused Fed Chairman Alan Greenspan of being part of a conspiracy by government officials to understate inflation and thereby boost estimates of real economic growth.

In the process, Social Security and other government pension beneficiaries are being cheated on their annual cost-of-living adjustments, Gross said in his monthly ``Investment Outlook'' column.

Owners of inflation-indexed Treasury securities are badly served because their values ``adjust inadequately to a faulty and near fraudulently calculated CPI that one day could total billions of dollars per year for (such security) holders,'' he said.

Calculating Inflation

Gross's biggest complaint about the CPI is that the Bureau of Labor Statistics takes changes in the quality of a good or service into account in calculating inflation. In other words, the increase in the price of a car due to adding air bags for the protection of people in it is pure inflation. That added protection has no value, according to his argument.

In contrast, few if any economists question the need to adjust for quality changes. Rather many of them complain that BLS quality adjustments don't go far enough.

Gross has particularly harsh comments about the bureau's use of a technique called hedonics as part of those quality adjustments. Hedonics involves determining the essential characteristics of a good, such as a computer, and adjusting its price according to changes in those characteristics.

``Today no less than 46 percent of the weight of the U.S. CPI comes from products subject to hedonic adjustments,'' Gross said.

``Talk about a con job!'' he exclaims. ``The government says that if the quality of a product got better over the last 12 months that it didn't really go up in prices and in fact it may have actually gone down.''

A chart accompanying Gross's column, labeled ``Hedonic Magic,'' purported to show that in the 12 months ended in July that the adjustments lowered the change in the CPI to 3 percent from 3.6 percent.

Not only is Gross's 46 percent figure inaccurate, the impact of hedonics on the change in the CPI is grossly exaggerated. Its use has essentially no impact on the overall index because some hedonic adjustments tend to raise the inflation rate, offsetting others that tend to lower it.

The CPI Adjustment

In fact, by weight, or importance in the index, just 33 percent of the CPI is subject to hedonic adjustment, not 46 percent, according to BLS officials. Three items, rents, owner's equivalent rent and a portion of the apparel category, account for almost 32 percent of that weighting.

Unfortunately for Gross's argument, hedonic adjustments for those items boost the index. That's because for the rent components, adjustments relate to the aging of the housing stock.

For the other items adjusted hedonically -- computers, televisions, audio equipment, video cameras, VCRs, DVD players, major appliances and college textbooks -- the rate of price increase is lowered. However, those items collectively account for a scant 1.1 percent of the index by weight. Computers and peripheral equipment, about which Gross writes a great deal, have a weight of only 0.23 percent.

`Substitution Bias'

BLS economist Patrick Jackman said in an interview that the overall impact of hedonic adjustment on the rate of change in the CPI is ``virtually zero.'' From 1997 to 2003, the use of hedonics may have lowered the cumulative rise in the CPI by 0.1 percent, he said.

Gross also includes cars among the items whose prices are adjusted hedonically, which is incorrect. Car prices are adjusted for quality changes directly based on the cost of a quality improvement, such as making an optional accessory standard.

The Pimco fund manager also derides what he calls the ``substitution bias'' in both the CPI and the personal consumption price index, which is part of the gross domestic product accounts.

``In addition, when `substitution bias' (a BLS maneuver that follows your preference for Chicken McNuggets vs. a Quarter Pounder) is eliminated, the gap (between an adjusted and an unadjusted CPI) gets even worse,'' he said.

Food and the CPI

The point is that consumers to some degree respond to changes in relative prices. In this example, for two products in the food-away-from-home category, a rise in the relative price of Quarter Pounders would increase the sales of Chicken McNuggets. The impact on the CPI is reduced because the cheaper product would carry a slightly greater weight. If the price of Quarter Pounders returned to its previous level, the increase in the CPI would be erased.

On the other hand, if the price of beef goes up relative to chicken in the food-at-home category, there is no substitution effect because beef and chicken are aggregated separately. If the price of a sirloin steak goes up relative to flank steak, the substitution effect would affect the index.

Don't consumers respond to such price signals? Of course they do. Why should they be ignored in calculating inflation? After all, the weights of individual items in the consumer market basket on which the CPI is based are updated frequently on the basis on consumer expenditure surveys.

The introduction of this substitution effect beginning in 1999 has lowered the increase in the CPI by only 0.2 percentage points a year, Jackman said.

Core Inflation

In addition to hedonics and substitution effects, Gross complains about the focus by policy makers on core inflation, that is, the consumer price index less food and energy items, rather than changes in the overall CPI.

``A low core number allows us to pretend that American productivity is the best in the world, that the dollar should be strong and that the markets, by golly, are going up,'' he wrote. And he notes that a salesman quoted in the Wall Street Journal said, ``People have to buy groceries and drive to work. It's not realistic to strip out food and gas prices.''

Of course that's not realistic, and that's not what the Fed does. Greenspan and his colleagues have had plenty to say about how rising oil and energy prices have hurt the economy this year.

The argument for excluding food and energy prices isn't that those prices don't matter. Rather, the concern is that they often are highly volatile with large increases often partly or wholly reversed. Even if oil prices remain high for an extended period, there's little reason for policy makers to assume they will continue to rise at anything like the pace of recent months.

Overlooking A Smoking Gun

As for pure volatility, quirks in the federal milk price- support program caused fresh whole milk prices to jump 14.7 percent in May and an additional 3.7 percent in June before falling 2.2 percent and 4.4 percent respectively in July and August. Should that matter very much in setting interest-rate policy?

Fed officials believe the core inflation indexes provide a much better guide to fundamental inflationary pressures in the economy, the pressures on which Fed policy is focused.

Besides, over longer periods of time, a focus on the core hasn't minimized inflation. For example, since 1989 the annual increases in the core have exceeded that of the overall index in eight of the 14 years, most recently in 2002.

The real surprise about Gross's column -- something that might have added credibility to the notion of Greenspan and a conspiracy to have a low inflation rate -- is that he fails to mention the Fed chairman's frequent assertion that the CPI overstates -- yes, overstates -- inflation by perhaps as much as a percentage point a year.

How could Gross have overlooked that smoking gun?

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net.

Last Updated: October 6, 2004 00:14 EDT