The error of relying on inflation indices – Twin Cities

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

Edward Lotterman

At this time of year, when adjustments in social security checks and tax classes come out, budgets for churches, school districts and condominiums are finalized, and this year’s inflation figures emerge, our frustration stems from widespread public confusion about price indices. What do they measure? What information do they provide? How can they mislead people?

Anyone who has ever sat on a finance committee knows the familiar beef: “Why does the budget grow faster than inflation?”

Economists’ mental reactions tend to be, “well, why the hell shouldn’t they?” But then we reflect on wisdom, even if it is ignored by Mr. Micawber, David Copperfield’s landlord and mentor: “Annual income twenty pounds, annual expenses nineteen, nineteen and six, result in happiness. Annual income twenty pounds, annual expenses twenty pounds should and six, resulting in misery. “

Many people think the same way. The church’s budget rises less than “inflation” or “cost of living”, no problem. Roast beef, cinema tickets or condominium fees increase more than these measures? Someone is abusing you. Travel the hell up!


Keep in mind that any price index, such as the well-known consumer price index or “personal consumption expenditure” fraction of the gross domestic product, involves finding the weighted average of the prices of thousands of goods measured in hundreds of places based on the buying patterns of hundreds of millions of people. Why should the price change for a single item anywhere for a single buyer be exactly equal to these overall national averages? It defies common sense, but it does a lot of thinking among the general public.

Almost everyone assumes that if the weighted average of prices rises by 5 or 6 percent, which 2021 will probably over 2020, they themselves spend exactly that much more for the same consumption. But exact correspondence in a given year applies only to a small proportion of households.

The prices of new and used cars rose in 2021. This affects the consumer price index. But not everyone wants to buy a car. If you do not, these price jumps will not affect you now. Our pickup and car were purchased in 2004 and 2007. So duffers like us faced insignificant increases in the fixed cost of driving over that range.

Of course, other people drive 50,000 miles a year and have to shop often. They are affected every two or three years. If they bought this year, they got a significant blow. Even low-mileage drivers like my wife and I get a hit every decade or so. But in the intervals in between, increases in car prices that offset CPI do not affect any of us who do not actually buy.

Homes are similar. House prices are rising, but they are durable “capital” items, not one used up like butter or shoes. Buy a house and you have exchanged cash for a tangible asset, but you have not “used” anything. And houses can be sold again, with the equity obtained either rolled into the new purchase or banqueted.

Now CPI includes rental rates for rented properties. The prices of owner-occupied homes are more difficult. The Bureau of Labor Statistics must calculate a corresponding monthly rent. This “owners’ corresponding rental of primary housing”, or OER, is rising as property prices rise, as now. But unless you buy a house during this period, your cash expenses will not increase. So the set CPI overestimates the “cost of living increase” for most households.

Also understand that for all items in the “market curve” measured for an index, prices must be averaged across the country. The meaning or “weight” assigned to this award is also an average of a range of amounts purchased by millions of different people. An increase in the price of natural gas or heating oil will be weighted by the average amount spent across the country, from Key West, Fla., To Nome, Alaska; Honolulu to Bangor, Maine. For a given increase in the price of natural gas, the increase in the cost of living for households in Havre, Mont. or Tower, Minn., thus being underestimated by the National CPI. They will be overrated for San Diego or Brownsville, Texas. Conversely, rising electricity prices will hit Phoenix or Atlanta residents worse than the national CPI indicates, but Duluth and Tacoma, Washington, will get off to a better start.

One could go on and on about the fallacy of relying on indexes. Few people die just at the “life expectancy” that is periodically announced during their lifetime, and few people experience an increase in their cash cost of living just at the “inflation rate” measured by CPI. Some do better, some worse and both often markedly.

This is also true because people’s personal consumption patterns vary from national averages that weight price indices. Vegetarians do not sweat rising meat prices. Slob like me does not crawl when menswear costs more. And anyone with generous health coverage, as for military Tricare coverage that we have, feels only a little of the cost of rising drug prices and medical procedures. People with poor coverage, or none at all, can get huge hits.

One last common misconception is to take an “inflation rate”, determined by household consumer prices, and use it to assess spending from a completely different, non-household unit.

One student I had was chairman of the school board for a large suburban district. The cost of gas to heat nine school buildings can easily reach $ 400,000 a month. A cold winter or rising gas prices could blow the district’s budget apart, yet some taxpayers would be furious because a frugal board had allowed outlays to “increase more than inflation.”

We are all like Mr. Micawber. Some monopolistic industry may erode us, but as long as the increases are less than “inflation,” we protest a little. Several producers in another highly competitive sector may not cover the costs, but if prices rise “more than the cost of living”, we shout outrage. For 40 years, I have never heard a consumer or taxpayer moan, “But it’s less than inflation.”

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