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Does the CPI understate inflation?
You're hearing this a lot these days, most of all from Kevin Phillips. David Leonhardt sets the record straight. Here is one excerpt:
During the 1980s and 1990s, though, did you ever stop and marvel at what a small share of your paycheck you were spending at the supermarket? I didn’t. I also didn’t really notice that gas cost less in the late 1990s than it had in the 1980s. Yet lately, every time my wife or I pass a new benchmark for filling up our tank — $40, $50 and now $60 — we have a conversation about it.
Price increases are simply more noticeable — more salient, as psychologists would say — than price decreases. Part of this comes from the notion of loss aversion: human beings dislike a loss more than they like a gain of equivalent size. If you have to sell your house for less than you bought it for, you’re really unhappy. You hate that ground chuck now costs $2.83 a pound, but you didn’t notice that oranges are 31 percent cheaper than they were a year ago.
...The price of major appliances has been flat over the last year. Furniture is 1 percent less expensive. A decade ago, a basic four-door Toyota Corolla LE cost $16,018, according to the company. The 2009 basic model costs $16,650, and it’s a safer, more powerful, more fuel-efficient car than its predecessor.
To top it all off, most people don’t buy any of these items very often. “People tend to remember things they do frequently,” says Stephen Cecchetti, an economist at Brandeis University who studies inflation. “And what do you buy more frequently than gas and food?”
Posted by Tyler Cowen on May 7, 2008 at 10:46 AM in Data Source | Permalink
Comments
Does anyone really think that inflation is overstated? How ignorant is that? Stop and think for one minute about how much the computer you are using to read this would have costed 15 years ago. To what extent is that taken into consideration when caclulating CPI?
Now do the same for your car, your TV, your MP3 player, your DVD player, your ..., well, you get the picture.
Posted by: Joe Torben at May 7, 2008 11:07:18 AM
I'm still confused by the CPI with respect to housing: if they peg it to what the owner can rent the place for it will always be behind what it costs to buy a home. People don't rent more than one place at a time but recently people have started buying more investment properties. With the population going up at a much slower rate (and thus the amount that rents can really go up) than the cost to purchase a house inflation is underreported.
Also it has been a long time since I've looked at CPI calculations but I recall there being the idea of a "basket of goods" that a consumer can buy at the supermarket. Can't buy beef this week as it is pricey? Just substitute cheaper chicken. While that reflects what people do it also underreports inflation.
Posted by: BlogReader at May 7, 2008 11:17:02 AM
Yes Joe, but for the things that I buy most often prices have gone up a lot lately. I rarely buy T.V.'s, MP3 players and DVD players.
For the people whose consumption as a percentage of income is mostly spent on food and transportation (poor people in the U.S.), inflation is almost surely understated. And let's not forget the food riots in other countries...
After I read the article this morning, I was left thinking "Give me a break." Maybe Leonhardt went to lunch with Ben Stein and decided everything was dandy, no reason to worry.
Posted by: stanfo at May 7, 2008 11:21:53 AM
stanfo,
Just because you buy those things more often doesn't mean you spend a larger portion of your income on them. Most people don't spend the largest portion on food & transportation actually -- most people spend a larger portion on housing.
Despite the housing bubble and the food price rise, in general the portion of money we spend on food/transport and housing has been going down. This means the overestimation of inflation has been going up (since new technologies and quality improvements in all other areas are understated).
Posted by: liberty at May 7, 2008 11:26:59 AM
Two things I find curious in the CPI calcs:
1. Imputed rent. The largest single component in the calc. This would suggest to me that as house prices fall, a huge chunk of the CPI would also fall--suggesting better times when in fact the result is people experiencing quite the opposite.
2. In the NYT infographic recently, health insurance seemed to constitute a tiny chunk of the index. (No percentage given.) What's with that?
Posted by: Steve Roth at May 7, 2008 11:51:33 AM
Joe - An average car would have cost about $12-15,000 twenty years ago, (see http://www.gti.net/mocolib1/prices/1989.html) or about 1/2 today. That is a compounded annual rate of about 3.5%.
You can make all the hedonic adjustments you want to get this rate down. But the real cost increase to a consumer remains the same as you cannot buy a car equivalent to the 1989 model any more. The other "trick" in the new CPI numbers was the substitution of rent for home prices. This had a dandy effect on the CPI over the past 15 years or so as home prices skyrocketed (not counted) and (counted) rental prices stagnated. If rental demand picks up going forward, this will have a negative effect on the CPI. The only question I don't know the answer to is how long it will take for rent prices to increase given the apparent housing oversupply.
And finally, a question for Tyler. Could not the dramatic decline in the US savings rate over the last 10-plus years be a system-wide "rational choice" signal of inflation (actual or expected) greater than official CPI numbers reflect?
Posted by: martin at May 7, 2008 11:55:04 AM
I understand that if you are in an accident with a Corolla, it automatically turns into a casket. Very efficient.
Consumer electronics are obsolete at least every 3 years. No wonder they are cheap. Look at VHS tapes. Useless. My kid's MP3 player didn't last 6 months. And does the CPI measure taxes? Property taxes never go down.
Posted by: jorod at May 7, 2008 12:05:15 PM
technology advancement isn't deflation. At least not in my book.
Neither economically nor practically. Sure, my MP3 player is cheaper than the one I would have had to commence my own R&D project to invent 10 years ago. But, I couldn't buy one then either and I've bought ~8 in the last 4 years. So, even though technology is cheaper, I've spent infinitely more money on it.
Posted by: Andrew at May 7, 2008 12:31:29 PM
Yeah, VHS tapes are useless, unless you have a VCR, in which case they still work just fine. I watch my old VHS tapes all the time.
And great example, by the way, since VHS was introduced almost 30 years ago and were the market standard for about 15 years (1985-2000).
Posted by: Bob Montgomery at May 7, 2008 12:40:38 PM
My father kept our first VCR going for about 15 years. My last three have lasted about 2 years apiece. DVD players aren't much better.
Is anyone keeping up with that and inflation? No, and they shouldn't. Inflation needs to be a policy issue. It has no meaning if we intertwine it with everything else.
I think it's probably understated, but I prefer the indicator to be consistent to accurate.
Posted by: Andrew at May 7, 2008 12:58:28 PM
"technology advancement isn't deflation. At least not in my book."
I don't understand this view. If I bought a computer last year for $2,000, and now if I went to buy a computer for $2,000 it would be twice as powerful, then wouldn't I expect the store to have a computer equivalent to mine at something like $1,000? How is that different than deflation?
Posted by: kebko at May 7, 2008 1:10:57 PM
The other thing is that the main "life event" money that people worry about has also gone up very quickly: health care and education, particularly higher education. Both are seen as necessary and both are seen as potentially ruinous expenses, particularly health care.
The things that have gotten cheaper are mostly one-off, discretionary expenses; you can always wait to buy a cooler TV, but if you need heart surgery or your kid is ready for university, it happens now.
Posted by: Foobarista at May 7, 2008 1:18:44 PM
Property taxes never go down.
Lies! Lies, I say:
Grayslake, Illinois
Walla Walla, Washington
Posted by: MostlyAPragmatist at May 7, 2008 1:33:17 PM
When did "prices rises" and "inflation" become synonymous?
Prices are simple the net effect of all things that affect price (including inflation, technology, productivity, supply changes, etc). If no inflation were present, prices would increase less (or decrease more).
Posted by: Rob at May 7, 2008 1:44:17 PM
"Despite the housing bubble and the food price rise, in general the portion of money we spend on food/transport and housing has been going down. This means the overestimation of inflation has been going up (since new technologies and quality improvements in all other areas are understated)."
The 'rule of thumb' for purchasing a primary home used to be 2-3x household income. What is it now - twice that?
Does the fact that savings rates are at an all-time low imply that everyone is spending discretionary income on baubles and trinkets, or is it possible that more of people's incomes are being allocated for increasingly expensive necessities? Real income has been falling for many Americans.
Posted by: at May 7, 2008 1:45:53 PM
Why is this so hard for everyone to understand?
- Thanks to the exponential growth of technology, manufactured goods and technological gadgets have become incredibly cheap. Thanks to the internet, you can get an infinite amount of music, movies, newspapers for virtually free.
- The government regulated sectors have become vastly more expensive. This includes education, housing, healthcare, and auto insurance.
- Mismanagement of the money supply has made property and commodities more expensive.
- The cost of earning a median income has increased. People work more hours, have longer commutes, and have to incur more debt for schooling.
Economists need to understand that's it's possible to have technological improvement at the same time as economic fundamentals are becoming much weaker. Silicon Valley is hiding the mistakes of Washington.
The general trend has been a decrease in the price of luxuries, while an increase in the basic costs of living. As someone who values free time over luxuries, I view this as a very bad trend.
Posted by: Patrick Fitzsimmons at May 7, 2008 1:46:54 PM
Just because there are goods whose prices actually decreased is still not a valid counterargument. It's not pure speculation to point out that prices of these goods would have even decreased more without a general increase in the price level. Inflation is not about some shifts in relative prices (it's a fallacy to believe that high petrol prices drive inflation), but about general price increases. Obviously, the CPI does understate inflation only due to the fact that they adjust their methodology in order to keep rates lower as they would be otherwise.
http://www.shadowstats.com/
I don't know how credible the source is, but it is nevertheless astonishing to which extent CPI rates differ according to the methodology employed (compare pre-Clinton and today).
Posted by: Sécessionniste at May 7, 2008 1:51:31 PM
I think inflation is correlated to government spending. As government spending increases beyond a ceratin level, inflation picks up. What we are now seeing is the result of President Bush and Speaker Hastert's spending policies. True, prices can go up and down but the value of money has generally been going down. You might tell your self a $16,000 car is the same as a $30,000 a year ago but you know it isn't. If you can only afford the $16,000 car now and your income is the same, what does that tell you?
Posted by: jorod at May 7, 2008 1:52:35 PM
Following my plan, I will concoct a theory of loss aversion, then do the background reading. I have reasons for purposefully being backward.
My theory, people fear price volatility and have a high preference for stability. Loss aversion would be derived from our fear of volatility.
The cause would be simple, we live our lives with promises of future production, promises which are estimated under the assumption of some stability. A loss of stability requires a near term renegotiation of the future, an increase in stability allows us to hold off the expensive renegotiation.
Now, I go back to the material, looking for a specific relationship between loss aversion and volatility.
Posted by: Matt at May 7, 2008 2:05:49 PM
"An average car would have cost about $12-15,000 twenty years ago, (see http://www.gti.net/mocolib1/prices/1989.html) or about 1/2 today. That is a compounded annual rate of about 3.5%.
You can make all the hedonic adjustments you want to get this rate down. But the real cost increase to a consumer remains the same as you cannot buy a car equivalent to the 1989 model any more."
Do you mean that in a good way or a bad one? Are you saying "we can't buy cars as bad as 1989 for the price"?
Yes, a Camary today is much better than the 1989 model. But you can get a KIA Spectra for about 14,000 of 2008 dollars which will be more fuel efficient and otherwise largely comparable with the 1989 Camary.
Posted by: Sebastian Holsclaw at May 7, 2008 3:06:14 PM
OK, as far as the efficacy of the CPI, it can be manipulated for propaganda purposes. And we can argue about it as an accurate indicater of inflation.
For the sake of argument, when shortages develop, profits increase, and more producers enter the field. At least in an open market.
Let's assume that manufactured goods are as good or better than goods of the past and productivity has negated inflation. But what about the long-term price of energy? We are left with the fact that demand for commodities such as oil has outstripped supply. We are left with this reality until supply increases or demand declines, or, more likely, a combination of both. It takes time to increase the supply of commodities.
What are the implications for this? Smaller cars, smaller houses, more energy efficient appliances until a new "equilibrium" is reached, that is budgets of households are adjusted for new price levels. Or will Congress allow oil companies to drill for more oil? How long will the adjustment period last? If more cars in the world mean more demand for oil, which should government policies be?
Has the enrgy crisis been engineered by political interests to push voters into a certain political or "crisis" frame of mind? Or for servcies, is there a shortage of medical services or has government restricted the supply through medical licensing and restrictions on building new hospitals? Is this truly an open market? Who is doing the policy analysis?
Posted by: jorod at May 7, 2008 4:02:21 PM
I would hardly say the record was set straight. How anyone can have any confidence in the accuracy of the inflation measures is beyond me. Hedonic adjustments, substitution effects, these are very complicated and difficult in practice to turn into an equation.
The entire measurement of price inflation is an odd practice. What exactly are they trying to measure? The cost of living, in some form, rather than the actual change in prices of goods (substitution effect, etc.). Trying to determine the change in the average cost of living for the population of a country strikes me as completely hopeless. What if your new computer is 10x as fast as your old one but you only use the word processor? Have you gotten more for less?
Everyone that says inflation is now as low or lower than officially reported MUST believe that officially reported inflation in the 70s/80s was dramatically overstated, since an entirely different methodology was then used. Was the market fooled? Were the interest rates, etc. back then completely off the mark? That seems like a very important question that I have never seen anyone address.
Posted by: Cliff at May 7, 2008 4:11:35 PM
The rubber meets the road in buying patterns. If we can continue equal buying year after year, on a similar wage, without hardship, there probably isn't much price inflation. If the same shopping, the same lifestyle, no longer works on that same wage, there probably is price inflation.
I think what happens with food and fuel is that people too close to the edge, suddenly find their budgets blown.
(FWIW, my two largest fixed costs, my condo association dues and my health insurance, both went up 10% last year.)
Posted by: odograph at May 7, 2008 4:31:50 PM
I like to cost things in minimum wage hours. By this measure most things are much cheaper than in the 1960s, 1970s and early 1980s.
(BTW It seems to me that some things got smaller (candy bars) and lower quality in the late 1960s and 1970s in response to inflation but things got bigger and better since 1980.)
Buildable lots and therefore homes and apartments seem to have risen in minimum wage hours but this could be viewed as a cost of slow growth policies than some see value in that. Even in homes middle class people no longer use formica counters but have corien or granite. They get real tiles etc.
As far as Gasoline goes the price is much higher now but engines are 50% or more efficient than they were 15 years ago and this should be factored in. The mileage did not rise because we used the increased efficiency to get heavier and faster cars.
Posted by: Floccina at May 7, 2008 6:03:04 PM
Cliff: How anyone can have any confidence in the accuracy of the inflation measures is beyond me. Hedonic adjustments, substitution effects, these are very complicated and difficult in practice to turn into an equation.
This hits the nail on the head. The real question is why so many economists take CPI so seriously when it is just a subjective formula, subject to manipulation depending on the interests of the politicians and bureaucrats who set it. Furthermore, for inflation CPI is a trailing indicator, lagging far behind price changes in commodities. It is utterly stupid to use CPI as an economic decision-making tool.
Posted by: nick at May 7, 2008 6:12:12 PM
