The mistake of trusting inflation indices – Twin Cities

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Sometimes being an economist can be frustrating like Hades, but knowing a little Dickens can help.

Edouard Lotterman

At this time of year, when Social Security check and tax bracket adjustments are released, church, school district, and condominium association budgets are finalized, and inflation figures for year are published, our frustration stems from widespread public confusion over price indices. What are they measuring? What information do they give? How can they deceive people?

Anyone who’s ever sat on a finance committee knows the familiar beef: “Why is the budget growing faster than inflation?” “

The mental reactions of economists tend to “Well, why the hell shouldn’t they? But then we reflect on the wisdom, though unaware, of Mr. Micawber, owner and mentor of David Copperfield: “An annual income of twenty pounds, annual expenses of nineteen, nineteen and six, result from happiness. Annual income twenty pounds, annual expenditure twenty pounds should and six, result in misery.

Many people think the same. The church budget increases less than “inflation” or “cost of living”, no problem. Roast beef, movie tickets or condo fees increase more than these measures? Someone is abusing you. Raise Hell!

Sigh!

Reflect that any price index, such as the consumer price index or the “personal consumption expenditure” fraction of gross domestic product, involves finding the weighted average of the prices of thousands of items measured at hundreds of places based on the shopping habits of hundreds of millions of people. Why should the price change of a single item in one location for a single buyer be exactly equal to these overall national averages? It defies common sense, but so do a lot of the general public’s thinking.

Almost everyone assumes that if the weighted average price increases by 5 or 6%, as 2021 will likely do compared to 2020, they themselves are spending exactly that much more for the same level of consumption. But a precise match in any given year is only true for a small fraction of households.

The prices of new and used vehicles increased in 2021. This influences the CPI. But not everyone will buy a car. If you don’t, those price hikes won’t affect you now. Our pickup and car were purchased in 2004 and 2007. So duffers like us had to deal with negligible increases in fixed driving costs during that time frame.

Of course, other people travel 50,000 miles a year and often have to redeem. They are affected every two or three years. If they bought this year, they took a big hit. Even low mileage drivers like my wife and I get hit every ten or two years. But in the intervals between the two, the spikes in car prices that raise the CPI don’t affect any of us who aren’t actually buying.

The accommodation is similar. Real estate prices go up, but they are durable “capital” items, which are not used like butter or shoes. Buy a house and you’ve traded money for a tangible asset, but you haven’t “spent” anything. And the homes can be sold again, with the equity earned being either incorporated into the new purchase or put into the bank.

The CPI now includes rental rates for leased properties. The prices of owner-occupied residences are more delicate. The Bureau of Labor Statistics must charge an equivalent monthly rental fee. This “principal residence owner equivalent rent”, or REL, increases with the rise in property prices, as it does today. But unless you buy a home during this time, cash expenses don’t increase. Thus, the tabulated CPI overestimates the “increase in the cost of living” for most households.

Also understand that for all the items in the “consumer basket” measured for an index, the prices must be averaged over the whole country. The importance or “weight” assigned to this prize is also an average of a range of quantities purchased by millions of different people. An increase in the price of natural gas or heating oil will be weighted by the average amount used across the country, from Key West, Florida, to Nome, Alaska; Honolulu in Bangor, Maine. So, for a given increase in the price of natural gas, the increase in the cost of living for households in Havre, Montana, or Tower, Minnesota, will be underestimated by the national CPI. They will be overestimated for San Diego or Brownsville, Texas. Conversely, rising electricity rates will hit residents of Phoenix or Atlanta more severely than the national CPI indicates, but Duluth and Tacoma, Wash., Will fare better.

We could go on and on on the confidence index fallacy. Few people die at just the periodically advertised “life expectancy” in their lifetime, and few experience an increase in their cash cost of living just at the “inflation rate” as measured by the CPI. Some do better, others less well, and both often markedly.

This is also true because people’s personal consumption habits differ from the national averages that weight the price indexes. Vegetarians don’t mind rising meat prices. Bastards like me don’t mind when men’s suits cost more. And anyone with generous health care coverage, as with Tricare military coverage as we have seen, feels little of the cost of rising prices for drugs and medical procedures. People with poor coverage, or none at all, can take huge hits.

A final common mistake is to take an “inflation rate”, determined from household consumer prices, and use that to judge the spending of an entirely different, non-domestic entity.

A student I had was chairman of the school board for a large suburban district. The cost of gas to heat nine school buildings could easily exceed $ 400,000 per month. A cold winter or soaring gasoline prices could cause the district’s budget to explode, but some taxpayers would be furious that a spending council had allowed spending to “rise more than inflation.”

We are all like Mr. Micawber. Some monopoly industries may rip us off, but as long as the increases are less than “inflation”, we don’t protest much. Several producers in another highly competitive industry may not be covering the costs, but if the prices go up “more than the cost of living” we cry out. In 40 years, I have never heard a consumer or a taxpayer complain, “But it’s less than inflation.

St. Paul’s economist and writer Edward Lotterman can be contacted at stpaul@edlotterman.com.


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