Yes, Inflation/Deflation is Hard to Measure

One of the hardest concepts for Principles students, politicians and pundits, oh heck, just about everyone to fully grasp is inflation.  A big part of the reason is because inflation is an abstract concept that is not directly measurable.  We can conceive of it, but we can’t measure it.  I’m no physicist (and open to correction) but it strikes me that it’s a bit on par with “momentum” or “latent energy” in physics.   We don’t have direct-measuring energy-o-meters.  We measure the effects and infer the energy.  Inflation is similar.  We can conceive of a generalized, across-the-economy, sustained trend pushing all/most prices upward such that the unit of money is losing real value in general terms.  Inflation is the sustained push behind all prices. We can’t measure that directly. But we can measure the effect it has: rising prices. The problem comes in that not all prices will be rising at the same time or by the same amount.  Further, during any time period, at least part of the change in price for any good is it’s change in real price relative to all other goods (supply and demand as taught in micro).

We try to deal with this measurement issue by creating a price index – an index that tracks the changes in shopping list of goods over time.  But any price index is a just a subset of all the prices.  Even the Billion Price Project index at MIT admittedly misses most services and lots of consumer goods that aren’t available online.  Price indices are very imperfect beasts.  They have many faults, not the least of them being that they often tend to be volatile in nature.  Since we’re looking for an estimate of inflation which means sustained increases, we need to massage the data further by creating some kind of “core inflation” measure or “trimmed means” type price index.  I’ll explain those some other time.

What prompted today’s post is an article in Bloomberg and a post by Krugman about it.  Together they illustrate one of the reasons so many people want to believe we have greater inflation than we really do.  Companies like to disguise price changes.  They don’t want to be known that prices could be cut in response to demand. Example: auto company offers $2000 rebate on $20,000 car but won’t cut price by 10%, or a firm offers a “value meal”, or they offer a freebie bundled product.  Similarly they often disguise price increases by reducing sizes or portions or by changing the financing.  From Krugman:

Good article in Bloomberg:

Procter & Gamble Co.’s failure to raise the price of Cascade dishwashing soap shows why investors are buying Treasuries at the lowest yields in history, giving the Federal Reserve more scope to boost the economy.

The world’s largest consumer-products company rolled back prices after an 8 percent increase lost the firm 7 percentage points of market share. Kimberly-Clark Corp. (KMB) started offering coupons on Huggies after resistance to the diapers’ cost. Darden Restaurants Inc. (DRI) raised prices at less than the inflation rate as patrons order more of Olive Garden’s discounted stuffed rigatoni than it anticipated.

This is basic economics; prices tend to fall, or at least slow their rise, when there is vast excess capacity and weak demand.

As both the article and Krugman’s excerpt show, we’re closer to deflation than most people realize.  They don’t see the failed attempts to raise prices.  They don’t see the shifts in portions or increase in coupons that reduce effective prices.  What they do see and remember is the $.50 increase in a loaf of bread or the $.70 increase in a gallon of gas.  But even with the gas, they selectively remember the $.70 price increase in summer, but forget the $.75 price drop in autumn.  Inflation and deflation are tricky things to measure.

 

John Stossel Fails an Education Test and Demonstrates That He’s Economically Illiterate

John Stossel is a Fox Business News reporter.  Stossel is an unabashed “libertarian” with a strong Austrian orientation on economics who focuses on economic issues.  He’s made a living out of being indignant and disgusted by “liberals” and “big government” which he sees as the root of all economic problems.  He’s been quite successful over the years, first at ABC News and now at Fox.   He also writes a blog to go with his Fox News show.

In other research I was doing recently I stumbled upon a post of his from Sept 15 called “Stupid in America” in which he asserts that schools have gotten too expensive and don’t deliver the goods.  In Stossel’s own words and graph:

School spending has gone through the roof and test scores are flat.

While most every other service in life has gotten faster, better, and cheaper, one of the most important things we buy — education — has remained completely stagnant, unchanged since we started measuring it in 1970.

It looks appalling right?  Scores have increased by 1% but the cost of an education appears to have increased by approximately 246% ($43,000 up to $149,000).  Except it’s very deceptive and the obvious product of an economic illiterate.  There’s two clear, elementary economic errors here.

First, he’s comparing test scores, a measure that’s in absolute terms on fixed scale to dollars spent in nominal terms over a 40 year period.  Dollars are not fixed units of measure.  They change value over time because of inflation.  If you want to compare test scores to dollars spent “buying” those test scores, then you need to use real dollars with the inflation taken out.

So let’s do that.  Using the Bureau of Labor Statistics CPI Inflation Calculator, we find that what $43,000 purchased in 1970 would require $241,660. in 2010.  Yes, inflation has changed purchasing power that much.  Inflation compounds so even a 2% annual inflation rate would more than double nominal costs in 40 years.  In the late 1970’s we had some years of inflation in the double-digits.  So really, the graph is telling us the opposite of what Stossel wants us to believe.

The second big problem is that Stossel is assuming that the all money spent on education goes to buying improved test scores in math, science, and reading.  He also is assuming that the inputs, the students being educated are the same in 1970 as in 2010.  They aren’t.  He ignores that we might be paying for something else in addition to math, reading, and science test scores.

Stossel then goes on the attribute all of the problems to education being a government monopoly.  Again, he ignores facts. Facts are inconvenient for Stossel.  Competition has been brought to K-12 education in many areas. Maybe not as much as he would like, but it’s a significant change since 1970.  As his test scores indicate, it hasn’t helped much.

Finally, I want to note that it’s poor practice to not cite your sources and more precisely define your data series.  The graph is labeled “Source: NCES”.  NCES is a huge website and archive of a lot of data.  Stossel doesn’t give a source. Is it because he wants us to take him at his word and not verify or check it out for ourselves? He doesn’t even label what the spending series is to which he refers.  I am assuming it is a “spending per pupil over 12 years” type of series.  A search of NCES for a series labeled as he has it turned up nothing.

I find it enormously ironic that Stossel would make such elementary errors as to not deflate a data series or to not label his measures precisely.  That’s what we demand in principles of economics courses.  What makes it ironic is that on August 23 Stossel takes Congress to task for being “economic illiterates” and not having degrees in economics or business.  Pretty rich stuff from a guy with only a psychology degree who makes elementary economic errors.

CPI: Deflation Watch

The September Consumer Price Index numbers are out. Inflation is really a sustained general increase in the level of all prices.  Since the price index itself can be rather noisy, varying a lot from month-to-month, many economists use some different techniques to smooth out the trend to see what the “sustained” action really is.  Three of the most popular ways of smoothing out the noise are called core CPI, median CPI, and trimmed-mean CPI.  In all three cases, the signals they are sending are not encouraging for recovery.  We are not yet into true deflation territory where prices are actually falling instead of increasing, but we are very, very close.  Both deflation and high inflation are undesirable.  But the risks are not symmetric.  Even very small amounts of deflation can be difficult to eliminate and can easily push an economy into a very prolonged period of stagnation or decline.  Inflation, on the other hand, can be more easily brought down if it gets too high.  Further, inflation at low levels, such as 2-4% isn’t very harmful at all.  In fact, a case can be made that 2-3% inflation is much more desirable than no inflation.

I like to think of managing inflation/deflation as driving down a desert road at the edge of cliff.  On the deflation side of the road is steep cliff with no guardrail.  On the inflation side of the road is a desert strewn with rocks.  Messing up and getting into inflation will get rocky and messy, but it’s manageable and survivable.  Erring on the side of deflation and things get real bad, real fast.   Best to leave a little margin of 2-3% inflation to make sure there’s no accidental plunge into real deflation.  For more than a year now, we’ve been playing daredevil with our economic futures by getting way too close to deflation.

Calculated Risk explains and offers one of their as-usual outstanding graphs:

…these three measures: core CPI, median CPI and trimmed-mean CPI, were all below 1% in September, and also under 1% for the last 12 months.

Inflation MeasuresClick on graph for larger image in new window.

This graph shows these three measure of inflation on a year-over-year basis.

They all show that inflation has been falling, and that measured inflation is up less than 1% year-over-year. Core CPI and median CPI were flat in September, and the 16% trimmed mean CPI was up 0.1%.

One last note about these numbers.  When The Fed increased it’s balance sheet dramatically two years ago to help bail out the banks and stabilize the financial system, the Austrians, Monetarists, gold bug types, and general austerians all complained that The Fed was leading us into a hyperinflation.  When the federal government budget blossomed into multi-trillion dollar deficit in early 2009, the same people warned us that it would lead to hyperinflation.  Now, 20-24 months later, we can conclude they were wrong. Their models are wrong and therefore the policy advice is wrong.  Deficits do not lead to hyperinflation when you have double-digit unemployment. Period.

CPI: What Inflation?

The anti-stimulus types who have been apoplectic about the FedGov Deficit warned us higher inflation, if not hyper-inflation would be just months away.  That was last year.

Let’s look at the data:

From the BLS report on the Consumer Price Index on Sept 17:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.3 percent in August on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. … Over the last 12 months, the all items index increased 1.1 percent before seasonal adjustment.

The index for all items less food and energy was unchanged in August … Over the last 12 months, the index for all items less food and energy rose 0.9 percent …

That’s DISinflation, meaning inflation rate continues to decline.  If it continues to decline, then we move from a positive inflation rate to negative – that’s deflation.  And monsters lie in deflation.

Inflation or Deflation? Look at Data

For nearly two years now the neoclassical, quantity-of-money-theory inspired folks have been fearing inflation.  Inflation, it has been said, was the necessary end result of the government deficits and central bank bailout efforts that helped keep the Great Recession from turning into Great Depression 2.0.  Let’s look at the data:

Inflation Measures Click on graph for larger image in new window.

This graph shows three measure of inflation, Core CPI, Median CPI (from the Cleveland Fed), and 16% trimmed CPI (also from Cleveland Fed).

They all show that inflation has been falling, and that measured inflation is up less than 1% year-over-year.

All this while the Central Bank (The Fed) claims it’s inflation target is 2-3%.  Sorry folks, the “inflation is coming, inflation is coming” chicken littles lose this one.  That graph is definitely going downward.  What we have to fear is deflation, not inflation.

Explanation: “Core Inflation”

Krugman explains “core inflation” and the measurement thereof:

So: core inflation is usually measured by taking food and energy out of the price index; but there are alternative measures, like trimmed-mean and median inflation, which are getting increasing attention.

First, let me clear up a couple of misconceptions. Core inflation is not used for things like calculating cost-of-living adjustments for Social Security; those use the regular CPI.

And people who say things like “That’s a stupid concept — people have to spend money on food and gas, so they should be in your inflation measures” are missing the point. Core inflation isn’t supposed to measure the cost of living, it’s supposed to measure something else: inflation inertia.

For the full explanation, go to the link.

CPI and Velocity of Money data for January indicate deflation worry

From Angry Bear:

Beginning of the year economic blues in the US? I think so. Just looking over Spencer’s CPI post; here is an excerpt (the first paragraph):

The CPI report was encouraging. The total CPI rose 0.2% and the year over year increase is only 2.6%. Although real average hourly earnings fell, real weekly earnings were unchanged.

The core CPI actually fell for the first time since 1982, bring the year over year change in the core CPI to 1.6%. The 6 month SAAR for the core CPI is 0.8%. Despite all the worries about inflation the normal pattern is for the best cyclical reading on the core CPI to occur in the first year or two after a recession. If the economy follows the normal pattern, the core CPI should continue to moderate for another year or two.

My first thought is that I don’t think that this is encouraging at all; and I’m not alone. Core prices fell; these prices are typically very, very sticky. For example, shelter prices are biased upwards in their calculations, but have been declining or unchanged for every month since August 2009. I know that the output gap is not directly observed, except by proxy in the capacity utilization numbers or the unemployment rate; but it must be huge to do this to housing costs.

Look at it differently: the velocity of money improved in October and November of 2009…

… but then took a step back in December of 2009. If this trend continues, non-energy prices are sure to back down much further. There’s just no support for price action at this time – the Fed can’t pull back… it probably should be putting more in.