You Decide: Is inflation measured correctly?

Dr. Mike Walden N.C. Cooperative Extension

March 2, 2014

The man’s tone was forceful, even with a tint of anger. “The government is lying to us about inflation,” he boldly stated. “They tell us inflation is a lot lower than it really is. And they purposely don’t include products like gas and food in their calculations to fool us into thinking the economy is better.”

I was finishing a presentation to a civic group with time devoted to questions and answers when the man made his statement. Perhaps he was looking for an argument, but I turned his points into a learning lesson about the process and pitfalls of trying to calculate the nation’s inflation rate.

The federal government has been collecting price data only since the early 20th century. This was the time of the Industrial Revolution, with people moving off farms and to cities. Rather than raising and making everything they needed, families began buying more products in stores – so the prices of everyday consumer items became more important.

Like the majority of government economic statistics, information about the prices we pay is based on a sample. Yet the government’s price sample is large, covering more than 200 categories of products and services at more than 20,000 stores. Also, it is incorrect to say the government excludes food and fuel prices. These are included in the survey and in the most commonly reported inflation rate. There is a version of the inflation rate which omits food and fuel, but only because these prices are very volatile and therefore may cloud the long-run trends in inflation. Still, this version is not the government’s main price gauge.

After the government collects the individual prices, each is assigned a “weight” based on its relative importance to the average household’s budget. So, for example, gas has a bigger weight than men’s ties. A weighted average price is then calculated, and the inflation rate for a year is the percentage difference between this year’s average price and last year’s average price.

It’s important to understand this calculated inflation rate is based on the spending pattern of the “average” consumer. But, of course, no one is exactly “average.” So, to the extent your purchases are unique and different from the “average,” then official inflation rates may be higher or lower than what you experience.

The government’s statisticians generating the inflation rate face three big challenges: One is that the collection of products and services people purchase changes over time. New products are introduced and others are discarded. Computers replaced typewriters, and cellphones are rapidly taking the place of landlines. Also, how and where people buy things change. Today, many more purchases are made on-line and at “big-box” stores than in the past. Over time, the government makes changes to keep up with the trends, but the adjustments can take time.

A second challenge arises when people change how much of a product they buy in reaction to a price change. Let’s say gas prices rise. In response, most motorists will purchase fewer gallons. This means the “weight” – the relative importance of gas prices to all other prices – may change. The government has a version of the inflation rate which attempts to account for this somewhat subtle – yet still important – impact.

Perhaps the biggest challenge – and the one with the most controversial solution – is how to deal with quality changes in products. For example, standard features on most new vehicles today include air-conditioning, power windows, CD player, and air bags — all items I didn’t have on my first car, a 1956 Oldsmobile! So it would unfair to include the cost of these features in the inflation rate for car prices between 1956 and today, because they represent improvements in the quality of vehicles.

The government agrees, and therefore it employs a statistical technique to remove the costs of new features so that the remaining price of the product allows an “apples to apples” comparison to earlier versions. It’s an imperfect technique, but without it the inflation rate wouldn’t only mean paying more for the same thing, but in part would mean paying more for a better thing.

And by the way, for the cost of owning a home — which is actually very complex, because a home is both something we use, as well as an investment – the government estimates the price per square foot if the home was rented.

The government releases several inflation rates each month, differing slightly by the kinds of specific methods used to address the above issues. For 2013, the rates showed a range between 1 percent and 1.5 percent for the annual inflation rate.

But there’s a private alternative to the government numbers. A couple of years ago, some economists at MIT decided to make use of the massive amounts of price data now available on-line to calculate their own inflation rate. They call this effort the “Billion Prices Project,” and it’s become a popular “check” to the prices and inflation rates published by the federal government. For 2013, the Billion Prices Project inflation rate came in at 2 percent.

So is there a logical and defensible way to estimate the inflation rate? Along with my skeptical friend at the civic meeting, you’ll have to decide.

Dr. Mike Walden is a William Neal Reynolds Distinguished Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of North Carolina State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy.