Is Inflation Really Understated? (No!)

Thursday, May 08, 2008 | 11:20 AM

Yesterday, I wrote: "David Leonhardt's NYT columns are oftentimes insightful and illuminating. Unfortunately, today's column is not one of those times . . ."  I promised readers (and David) an explanation. Consider this it.

First off, I interpreted Leonhardt's column as really two distinct issues -- one psychological, one statistical. He got the first one right, but muffed the second.

The psychological concepts of recency effect and salience were dead on. Gasoline is the only consumer product that has 6 foot tall prices on street corners and highways. We see gas prices more readily than we do many other items. So the visibility -- Salience -- is very high. Additionally, drivers tank up every week or more. You cannot help but see and feel the prices more acutely than other items.

The same is true for food prices. You see supermarket prices more readily than many other items, shop for them more regularly. When a restaurant menu has to use stickers to update new menu prices -- they change too rapidly too print new menus each time -- you notice it.

The Psychology of inflation is a genuine factor in how people feel. On these issues, the column correctly described the angst behind frequent purchases.

Perhaps it is a matter of emphasis, but I thought the column's tone and content failed to adequately address other realities of price changes in the US.

Let's look at these explicitly. Consider the following realities:

- Education, Health Care, Housing, Insurance, Property Taxes are not as visible as food or energy. However, they have all risen tremendously in price;

- David mentions that Prices were flat in the 1980 -- but that followed a huge spike in the preceding decade, the inflationary 1970s. That points to the impact of the Fed more than anything else. In the 1970s -- and the early 2000s -- the Fed dropped rates, allowing more inflation than is comfortable.

- Prices do not necessarily rise smoothly; they seem to sawtooth, rise abruptly, stay the same for a period, rise abruptly again. When this huge run in commodities ends -- as all bull markets eventually do -- would it surprise you to see prices flat for 2 decades?

- Even with the recent pullback in Housing, prices remain significantly elevated; By many traditional metrics (i.e., median incomes to median home prices) Houses are cheaper than they were in 2005/06, but much more expensive than prior years.

- Owner's Equivalent Rent (OER) -- the BLS method of accounting for housing expenses -- is flawed, but not quite in the way the column suggested. First off, it fails to account for increases in utility costs, property tax increases, and rising maintenance expenses. Additionally, while OER understated inflation when housing prices were rising  -- due to the falling rental market -- it may not be overstating them on the way down. Why? The excess inventory of homes for sales have become rental units, and in many markets is depressing rental prices.  (UPDATE: See Tim Duy: Misunderstanding the CPI for more on this).

- Core Absurdity: The idea of eliminating "Volatility" by ignoring prices in food and energy is ridiculous. If one wants to smooth the data or pull out price fluctuations, you should use a moving average. For example, as Oil ran from $20 to $120, the concentration on the Core didn't reduce volatility, it instead eliminated a huge source of Inflation.

- The same is true for the doubling and tripling of food prices over recent years.

- Speaking of food, the BLS concept of Substitution is more nonsense.  When Steak goes up in price, and consumers choose chop meat instead, that does not mean there was no inflation -- it means you have been price out of steak. (No mention of that in the column)

- Also omitted: Hedonics -- quality adjustments -- which have claimed that falling prices are deflationary. See our prior discussion: Technology Adoption Lifecycle as to why they are not (go to #3).

- If hedonic quality improvement is anti-inflationary, what about corresponding drops in quality? The low, low price retailers sell cheap clothing, but subjectively speaking, the quality has been decreasing rapidly. Where's the Hedonic adjustment for that?

- Sometimes, skepticism is deserved. Each of the major BLS changes in CPI data have resulted in a significant shift downwards in price reporting:


Courtesy of San Diego Union Tribune



Lastly, as to the conspiracy theories, I have my own take on it: The government doesn't respect you enough to lie. They actually put out all of the official statistics reach month for anyone with the time and interest to plow through them. All of these data runs, adjustments, changes to CPI, historical data -- its all online, waiting for you to review it, and be mollified or outraged.

Most people don't bother . . .



Seeing Inflation Only in the Prices That Go Up
NYT, May 7, 2008

The Fed's inflation gauge isn't realistic, critics say   
Dean Calbreath
San Diego UNION-TRIBUNE, April 17, 2008

GDP, Inflation & Recession

Is the Fed Causing a Global Food Crisis?

Inflating Our Way Into Recession

Thursday, May 08, 2008 | 11:20 AM | Permalink | Comments (32) | TrackBack (0) add to | digg digg this! | technorati add to technorati | email email this post



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"The government doesn't respect you enough to lie."

But it fears us enough to obfuscate.

Posted by: Marcus Aurelius | May 8, 2008 12:15:28 PM

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