You Decide: Which inflation measure should win?

Published 4:16 pm Monday, June 17, 2019

By Dr. Mike Walden

Most of the time when economics makes the headlines it’s about big things, like recessions, trade wars, tax changes and jobs. But economics also deals with smaller, technical matters – things that are boring to most people but fascinate those of us who have spent our careers in the “dismal science.”

So when one of these technical components of economics makes headlines, that’s reason to sit up and take notice because it doesn’t happen often. So straighten up and look alert, because one of these rare events just happened.

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It has to do with how to measure changes in the cost-of-living – also known as inflation. Many federal programs, such as Social Security, and a variety of public assistance, are indexed to inflation. This means their monetary amount rises by how much inflation has changed. For example, if the inflation rate is two percent this year, then next year the payments from the programs will rise two percent.

Why is this done? It’s so the funds distributed by the programs maintain their purchasing power over time. Continuing with my example, if the inflation rate is two percent – meaning the cost-of-living increases two percent – then the amount of money from the programs needs to rise by two percent to buy the same quantity of goods and services.

Obviously, if inflation is used to adjust program payments, then how inflation is measured is crucially important. Here’s the process that’s been used. The federal government identifies over 80,000 products and services most people purchase. This is called the “market basket”. The government then tracks monthly prices of each item in the market basket at over 20,000 shopping outlets. In calculating an overall cost-of-living, each item’s price is weighed by the proportion of total spending devoted to that item.

This means prices of items with larger weights – like housing and transportation – receive more importance in the overall cost-of-living than items with smaller weights.

Let me quickly dispel one misconception about the government’s measure of inflation. The misconception is that the government purposely avoids including some key items – specifically food and fuel – in the inflation measure. While there is a measure of inflation that does exclude food and fuel (the measure is called “core inflation”), that measure is used for other purposes and is not used for the annual adjustments in program spending.

One of the key issues in the inflation calculation I just described is the “market basket,” and particularly how often the market basket is updated. Traditionally the market basket was formed using spending diaries kept by a sample of consumers. Unfortunately, it takes a long time to collect and process this information, meaning that a market basket used today might be two or three years old.

This has created two problems. First, the market basket might not reflect exactly what consumers are buying. Second, even if it did, it likely wouldn’t reflect the amount of each item purchased. This second problem can result in the government’s measure of inflation being higher than actual inflation.

How so? One of the ways consumers respond to price changes is to change the amount – or quantity – of items we buy. Consider two sources of protein – beef and pork – and assume the average consumer purchases some beef and pork every month.

Now let’s say the price of beef significantly rises but the price of pork doesn’t change. What should a smart consumer do? The consumer will reduce the amount of beef she buys and replace it by buying more pork. In other words, she substitutes more of the now more affordable pork for some of the now costlier beef.

But the traditional way of calculating the inflation rate wouldn’t pick up on this until later because the market basket is fixed. As a result, the traditional method of measuring inflation will actually overstate actual inflation. Since this is a perpetual problem due to the market basket being outdated for several years, economists have estimated the traditional estimate of inflation overstates actual inflation by as much as a full percentage point.

The government has been working on a new inflation measure that better tracks how much of each item people are buying. That is, the new measure keeps up with how people change their market basket as prices change. The new measure is called the “chained consumer price index”, and it’s now ready to be used.

But there has been controversy over adopting the new measure because it will result in smaller inflation rates than the traditional method. Some people have cried “foul” because they think the new inflation measure is designed to give them less dollars in the future than the traditional method.

Those defending the new measure reply it is not meant to give anyone less. Instead, the new measure is meant to more accurately reflect the amount of inflation that actually occurs.

So there you have it – a controversy related to technical adjustments made by statisticians and economists. Part of me is proud because the folks with the green eye shades (does anyone still wear those?) finally have some time in the spotlight.

But in all seriousness, this is an important matter. My job is to give you the facts and the reasons why. Then I’ll let you decide which contender – the traditional inflation measure or the new, improved measure should be the winner!

Dr. Mike Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook and public policy.