Real and imaginary inflation

The Consumer Price Index (CPI) for June increased 0.3% from May, mainly driven higher by rising gasoline prices. Over the past 12 months, the CPI has increased 2.1%. Don’t worry; the Federal Reserve (Fed) isn’t going to imminently increase rates. The Fed looks at the price index for personal consumption expenditures (PCE), not the CPI, for measuring inflation. Plus, as Charles Evans of the Chicago Fed made clear, inflation running a bit over the Fed’s 2% target isn’t a reason for concern. That is especially true when higher inflation is driven by increases in food or energy prices, which tend to reverse themselves over longer periods of time.

Some people—a minority of investors and people who claim to be economists—think that the official statistics on inflation are hiding real inflation. You see gasoline prices higher, food prices higher, companies putting less product in packages, and government statisticians resorting to voodoo techniques like imputations and hedonic adjustments to conceal the truth that inflation is rampant. To put it politely, that’s a bunch of baloney. While food and energy prices are higher, they are off their 2011 highs. Plus, for your average urban resident, food and energy make up around 20% of monthly spending. What’s going on with that other 80% also matters.

Yes, the CPI incorporates imputed items, like owners’ equivalent rent, but there are other measures of inflation, like the PCE market-based measures that don’t include imputations, and those corroborate the story of low inflation as measured by the CPI. Plus, actual rents can be compared with owner equivalent rents, and the real purpose of estimating what rent owners could charge for their own homes is to appreciate the fact that there is an implicit cost to owning a home, even if it doesn’t result in cutting a check every month.

Hedonic pricing is a helpful method of comparing price changes across short periods of time when there are changes to the quality of goods and services. Using it for longer-term comparisons is more problematic considering the iPad of the 1980s was an Etch A Sketch. Still, hedonic adjustments are supposed to reflect that the effective price of something drops when the price doesn’t change but the quality significantly improves—like, how cars are much safer today than they were at any other point in history.

There’s also a salience aspect to how people perceive inflation. People tend to ignore price drops and only pay attention to price increases. For example, while ground beef prices were up over 11% from June 2013 to June 2014, did you know that lamb and mutton prices were down 13.2% and that cookies were 1.3% more expensive, but doughnuts were 1.2% cheaper? When relative prices change (that is, when cookies go up in price and doughnuts go down in price), people change the basket of things they buy, substituting cheaper items for more expensive items (buying more doughnuts and fewer cookies). Even if you personally don’t do this, when you look at a large group of individuals—whose purchases are what the CPI represents—small changes by large numbers of people really add up. Sure, your personal inflation experience may be very different than the average inflation experience, but the aggregate statistics are measuring groups of individuals, not you personally.

I suspect we will hear more and more discussion about how real inflation is running hotter than the official statistics represent, but that’s more imaginations run amok than a rational consideration of the facts. Inflation is low, and it’s likely to stay low for a long time.

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