Outside the Beltway

Inflation Not as Bad as You Think?

James Joyner · Wednesday, May 7, 2008 · 3 comments

David Leonhardt argues that, despite the belief that the Consumer Price Index understates inflation, the opposite is really true. The problem, he contends, is that everyone is keenly aware of rising prices but most people are oblivious when costs go down.

In 2003, a pound of hamburger cost all of $2.20. More than two decades earlier, in 1980, it cost $1.86, which means that the nominal price of burger meat rose only 18 percent over a period in which the nominal hourly pay of the typical American worker rose 150 percent. Similar stories can be told about eggs, bananas, bread and frozen orange juice. Food was getting cheaper relative to everything else, as Neil Harl, an agriculture professor at Iowa State University, explained to me, because of a combination of government subsidies, global trade and the rise of industrial farms.

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.

There is also something particular to inflation that aggravates loss aversion. Price increases are obvious. But price declines are often hidden. The cost of an item stays about the same for years, while everything else gets more expensive and nominal incomes rise.

When you dig into the Consumer Price Index, you start to realize just how many things fall into this category. 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?”

Indeed, gas prices seem to have a peculiar psychology attached to them. Not only do we buy it frequently, but everyone’s prices are in gigantic signs visible from the road. People who couldn’t tell you within a dollar what they pay for a gallon of milk know to the penny what they pay for gas — and will often go out of their way to save a couple cents a gallon.

The way the statistics themselves are calculated and talked about add to the problem:

The conspiracy theories about inflation play off these human instincts, but they also depend on two other oddities. The first is the amount of attention given to the so-called core inflation rate. This is a version of inflation that excludes food and energy, which makes it a little like a grade point average that excludes math and French. The core inflation rate does have a purpose. Its movements help Federal Reserve officials base interest rates on underlying price trends, instead of being overly influenced by food or gas prices, both of which can be volatile. But when Ben S. Bernanke, the Fed chairman, talks publicly about core inflation, he can leave the impression that the government is cooking the books. In fact, all the important economic indicators, including real wages, are based on overall inflation, as are Social Security checks and cost-of-living raises.

The final piece of the puzzle — and the focus of the Harper’s article — is the way that the Bureau of Labor Statistics has changed the price index recently. Back in the mid-1990s, a committee of academic economists concluded that the Consumer Price Index overstated inflation. To take just one example, years would often pass before the index included new products — like cellphones — and therefore it missed the enormous price declines that occurred shortly after those products entered the mainstream. In response, the bureau tweaked the index. But economists who have studied the changes say they have had only a modest effect on the inflation rate, lowering it by perhaps a half point a year. More to the point, the changes seem to have made the index more accurate than it used to be.

Quite right.

To be sure, the poorer you are, the less any of this matters to you. If you’re barely getting by, even modest increases in the price of food and gasoline have an enormous impact on your standard of living and, of course, you’re not consuming a lot of modern luxury items recently introduced into the index. But the inflation rate is supposed to describe the aggregate economy, not how things impact any given consumer.

via Tyler Cowen