Understanding the Market

Measuring inflation is more complicated than it would seem at first. It is fairly easy to view the price of gasoline from the big signs at many major intersections. Average gas prices are almost double the level of a year ago (see here for US retail gasoline prices); many Americans buy gas regularly and are aware of the price rise. The prices of some other goods have also risen sharply, from vegetable oils and rice and wheat to cable television and health insurance. If all these prices are rising (as well as others like college education and airfare) then it seems hard to believe the government’s published numbers that claim that overall prices (as measured by the Consumer Price Index) were up 4.2% in the last 12 months; the claim that core prices (excluding food and energy) were up only 2.3% is likely to be treated derisively by those who believe that the price of the things that went up from the inflation calculation (see here for one of the more carefully thought out expressions of this view).

Yet official inflation series present fairly low estimates of inflation

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, raising speculation about secret government efforts to understate the inflation rate (see here for a fairly mainstream version of this argument by a famed bond fund manager; articles such as this one from Bloomberg News use slightly more provocative language).

To better follow these arguments I will first discuss some of the problems of measuring inflation. Future topics will include a review of several popular monthly inflation indices

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, the CPI, PPI and the PCE deflator.

First a bit of definition: a price index tries to capture the level of prices at a specific time; the change in the level of prices is called inflation (or deflation

, if the change in prices is negative). Note that inflation and deflation are merely statements about the change in an index and not any statement about other economic conditions. Because deflation has occurred during some difficult economic times (such as the 1930s in the US or more recently in Japan) some people confuse deflation with recession or depression. But deflation and inflation are merely statements about the direction of change of the price level and nothing more.

There are numerous problems with calculating price levels and inflation; I will briefly speak of three of them, though there are others. Consider first a very simple economy with one good that does not change over time; the price level in this economy is just the price of the one good. It is very easy to compare prices over time; some years the price of this good will be higher and there will be inflation, other years it will be lower and there will be deflation.

The three major problems when we try to move from the simple economy described above to the actual economy of today arise from the observation that there are many goods (and many prices)

, so (1) our consumption basket changes over time, (2) the goods change over time and (3) not everyone consumes the same basket.

The people who believe that inflation is overstated argue that the price of gasoline (as noted above) has doubled in the last year. But (1) many of us consume less gasoline now than we did a year ago, driving less or using more efficient cars; (2) gasoline has changed somewhat over time, with the addition or removal of certain ingredients to increase the octane rating or reduce the negative effects of gasoline on the environment and (3) different people consume different amounts of gasoline, depending on where they live, what kinds of cars they own and how much they drive. So if the gas price is up 100%, but there is a new additive that has slightly increased the octane level and I drive much less (but still much more than you) how exactly do we compute the appropriate inflation number?

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, many of us use more computer services than we did, say, ten years ago; some of those services are far cheaper than they were (if they even existed then). High speed internet was fairly new and expensive in the late 1990s and it is now cheaper and faster; I probably spend more each year on computer-related services (including hosting this web site) than I do on gasoline.

Without getting into the mathematics (but there is a reasonably clear explanation in Wikipedia if you are interested) there has been a lot of time devoted to trying to carefully deal with these issues but each method involves serious compromises.

As noted above, there are a number of different inflation measures (calculated by different government agencies) that are used to describe inflation; I will provide a brief overview of the different measures here with more detail in specific essays about each measure.

The CPI (consumer price index) calculated by the BLS (Bureau of Labor Statistics) is the best known U.S. price index. CPI data are published once a month and try to measure the prices paid by urban consumers for goods and services. Two numbers attract the most attention

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, the overall inflation rate and the “core” rate (excluding food and energy); the first number measures the price of the entire basket and the second subtracts the cost of food and energy that are typically more volatile than other prices, meaning that large changes tend to be reversed over time. Some analysts believe that recent price increases in food and energy are unlikely to be reversed and they tend to ignore the “core” rate (which is much lower than the overall inflation rate).

The PPI (Producer Price Index) is also published by the BLS. In contrast with the CPI (which tries to measure prices from the perspective of the ultimate buyer of the goods and services) the PPI measures prices from the perspective of the seller. To the degree that retailers pass through the prices that they pay for goods, changes in the PPI should be a good predictor of future changes in the CPI (if the price of fish sold by wholesalers rises, the likelihood is that stores will raise their prices to retail customers). But in recent years the link between wholesale and retail prices has been less clear, possibly due to changes in the way business is done. Financial markets appear to pay less attention to PPI than CPI (one curious note is that up until a few years ago PPI data were routinely released prior to CPI data, but now CPI data are released first; the earlier release of the PPI led some to use it as an aid in forecasting the CPI).

The PCE deflator starts with the CPI data but also incorporates other data. The Bureau of Economic Analysis (the group within the Commerce Department that calculates the GDP) calculates monthly estimates of Personal Consumption Expenditures as part of the Personal Income report. The most important difference between the two measures of inflation is that the CPI uses a fixed-weight market basket (reset every ten years or so) that assumes that consumers continue to buy the same goods even if prices change; in contrast the PCE uses a so-called “chain link” method that reflects the monthly changes in the basket. Also, the basket for the PCE is somewhat larger than the basket include in the CPI (see here for a brief description of the differences). The PCE data are reported after the CPI\ data (data for April 2008 CPI were released on May 14, data for the PCE deflator were released on May 30); the Fed has used the PCE core index (ex-food and energy) as its measure of inflation (see footnote one in this PDF document)

This entry was posted on Tuesday, June 24th, 2008 at 4:13 am and is filed under Economy. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.