Inflation Measurement

CPI Inflation

The monthly CPI announcement gets the lion’s share of inflation attention, but it’s only half the story. The other side of the story is income.

Is your income keeping up with inflation? If it’s not, that’s what I call real inflation.

A good point to be aware of, the Fed makes a distinction between headline inflation and core inflation.

  • Headline inflation is the increase (usually, but not this month) of the cost of purchasing a statistically maintained market basket of goods and services.
  • Core Inflation is the increase in the cost of purchasing the market basket less the food and energy goods and services. Why are they removed? Because their prices bounce around quickly to external factors that Federal Funds policy can’t easily effect. Used for Fed rate decisions.

Headline inflation is the basis for social security adjustments announced annually. Before retirees get too excited, it’s important to note that the announced CPI is for Urban and Clerical workers, with 7.5% of the market basket set aside for health care. That CPI increased 2.5% annually from 1991-2011, while healthcare costs increased 6.1% annually in the same period.

Core inflation is an important distinction when noting monthly changes and deciding on policy responses – rate changes typically take 9-12 months to work themselves into the economic system. Of course, the changes to food and energy prices can’t be ignored in the longer term. Energy and food make up 23% of our living expenses (in the statistical basket).

The sticker shock you get in the grocery store is apparent inflation. Real inflation occurs when your income can’t buy the same daily goods with your salary or when you have to work longer to earn enough to purchase that market basket.

Change in CPI Purchasing Power

Let’s look at the change in purchasing power within the US as shown by how the change in the number of work hours required to purchase the CPI basket. Because the raw good prices in the CPI are not released by BLS, I will use the CPI values over the years as a reflection of the apparent change of inflation, despite the shortcomings of the index, e.g. income taxes are not considered, because they are not connected with the purchase of goods and services. Also property tax increases are only quite indirectly measured, through owner’s equivalent rent (i.e. to the extent that property taxes influence rent).

Figure 1

In Figure 1, the blue line shows increasing hourly median wage against the left column. The gyrating red line indicates how much CPI can be bought for an hour’s worth at the median salary level.

Over the 2002-2013 period, CPI has increased 2.4% per year. Median salary has nearly matched that. It’s grown 2.2% per year. Thus real inflation has grown about 0.2% in the past 12 years, very benign.

I am surprised by the no inflation result. That doesn’t seem to match the inflation experience most people report. A couple caveats: median hourly salary doesn’t how many hours these employees actually worked and more importantly doesn’t address those not working.

Big Mac Purchasing Power Parity

Although average hourly salary has risen steadily since 2002, the number of Big Mac that salary can buy has fallen from more than 5 to less than 4. That's real inflation, as experienced by the average worker.

Although average hourly salary has risen steadily since 2002, the number of Big Mac that salary can buy has fallen from more than 5 to less than 4. That’s real inflation, as experienced by the average worker.

The Big Mac index was conceived and has been kept current by the Economist to compare purchasing power across countries, yet it also allows us to compare US purchasing power across time. In figure 2, the red line showing how many Big Macs are earned by an hour of a median salary effort. It slopes down to the right. The median worker can buy less and less with his hour’s effort, despite his increasing dollar wage, shown with the blue line. Why? The Big Mac’s price is increasing faster than his salary. Since 2002 the nominal price of a Big Mac has risen from $2.49 to $4.56 (83%) , equivalent to an apparent annual rise of 5.6% . The median salary over the same period rose from $13.31 to $16.87 (27%), equivalent to an annual increase of 2.2%. The real inflationary effect is 3.4% (5.6%-2.2%).

Reflection On Inflation Measurement

Since 2002, as measured by the CPI, there has been low apparent inflation pretty closely balanced by low median salary growth yielding steady purchasing power.

However that impression is countered by two factors.

  1. CPI ignores income taxes collected by states, municipalities and the federal government. They have gone up, both by legislative action and by tax table bracket creep, due to increasing nominal (non-inflation adjusted) income.
  2. The government has two contradictory goals in reporting inflation. It wants it as low as possible to limit the increases due to indexed-linked changes, like social security. On the other hand, it wants it to be high, making it easier to pay off existing government debts with cheaper dollars.

The government wants inflation to be high, but reported low.

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