Inflation isn”t what you think it is
Unless you’re a self-sufficient hermit living off the grid, you probably think about inflation these days.
You’ve seen gas prices rise in the last year to well over $2 a gallon. You note that 50 bucks doesn’t put as much in a shopping cart as it used to. And if you open the newspaper or listen to the evening news you hear that inflation might be on the rise, with implications for interest rates, the stock market and Grandma’s Social Security check.
But there are many myths and misunderstandings about inflation, and one ugly truth.
First, recognize that a rise in the price of one good or service is not in itself inflationary. Inflation is a rise in the average of all prices in the economy. Deflation, more rare in modern economies, is a fall in average prices.
Gas prices make the news, but we take for granted the enormous decline in the price of computers. Because some prices rise and some fall, and because they rise and fall by different amounts, we must average the price changes to determine the rate of inflation.
When economists at government agencies calculate average price changes, they don’t perform a simple average. Rather, they give more weight to items that are more important in a consumer’s budget, such as changes in the price of housing and food, versus a change in the price of entertainment goods. That’s because most of us spend more on housing and food than we do on entertainment.
Because every consumer has a different spending pattern, everyone experiences a different inflation rate. You read and hear about the inflation rate, but there’s no such thing.
The most common estimate of inflation comes from a price index created by the U.S. Bureau of Labor Statistics. You’ve probably heard of it — the Consumer Price Index, or CPI for short.
But did you know that CPI inflation is a measure applying only to the average urban worker? The term “average” here means average spending patterns and average price changes for the goods and services in each expenditure category. If you’re a retiree living in a rural area you have a different spending pattern and face different price changes than the average urban worker. CPI inflation is only an approximation for you, and the more your spending differs from that of an average urban worker, the worse the approximation becomes.
But that isn’t the ugly truth about inflation.
The ugly truth is that it’s measured incorrectly, and the systematic bias is to overstate the rate of inflation. While people at the Bureau of Labor Statistics are working hard to correct deficiencies in inflation measurement, economists estimate the agency overstates inflation by as much as 1 percentage point a year, maybe more. The bureau fails to account adequately for changes in the quality of goods and services, and for the obvious fact that consumers buy fewer goods that are experiencing the steepest price increases, thereby reducing the effect of the increase. The agency doesn’t incorporate new products in the index fast enough, so it misses the initial price decline as new products move through their life cycle. And finally, the bureau underestimates the American consumer’s tendency to switch to discount outlets when they become available.
The overstatement of inflation is such that Alan Greenspan, chairman of the Federal Reserve Board, doesn’t even use the number. He prefers something called the personal consumption expenditure deflator (PCE) calculated by the Department of Commerce.
The difference in the two measures of inflation is no small matter. From 1980 to 2004 the CPI says the average price level rose 129 percent, while the PCE showed a much smaller 107 percent increase.
Despite its shortcomings, the CPI is widely used as a measure of inflation.
Many wage contracts have cost-of-living adjustments related to the CPI. Social Security checks are bumped according to CPI inflation. In taxes, the personal exemption, the standard deduction, and federal tax brackets are based on this inaccurate measure of inflation.
The CPI hasn’t been fixed because the politics aren’t pretty for incumbent members of Congress. A lower inflation rate means lower Social Security increases and higher taxes. Not many politicians want to hit the campaign trail with that record.
There’s one last thing about inflation: no matter how it’s measured, it helps many people.
These are folks who have debt at a fixed interest rate, such as a mortgage or student loan. If their wage or salary keeps up with inflation, which has historically been the case, inflation is the best thing that could happen to them. Every month, the real value of the mortgage or student loan balance is eaten away by inflation’s effect on the purchasing power of money. Month after month, those folks have to work fewer hours to make a mortgage or student loan payment.
That’s a good deal — unless you’re a lender, where the reverse holds. To protect against inflation, lenders have been eager to offer variable-rate loans.
Some gain, some lose from inflation. It redistributes wealth and income in a sneaky way. Now that’s ugly.