Broker Check

Thoughts on Inflation- Part One

| March 22, 2019
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"If inflation is so low, why are things so expensive?"

That's a good question, and if you'll hang with us for a while, we'll answer it.

Background

Each month, the U.S. Bureau of Labor Statistics (BLS) releases lots of statistics about inflation. You've seen references to the Consumer Price Index (CPI). Broadly, that's a measure of inflation for consumers, intended to show how much more costly a basket of goods and services is from one time to another.

You might think the BLS simply prices a whole bunch of goods and services, compares the cost, and declares the price difference as the official rate of inflation.

You might think that…but you'd be wrong!

Seasonal Adjustments

First, there are "seasonal adjustments."  Anybody who's bought flowers for a loved one on Valentine's Day knows that the price of roses goes up around the middle of February. Produce is usually more expensive outside of the prime growing season. Gasoline prices tend to rise in the summer during vacation time, and fall after Labor Day.

In other words, factors other than the underlying cost of producing a good or service can impact prices, and the BLS tries to eliminate those seasonal effects from the its measurement of inflation.

Quality Adjustments

But there are also changes in the quality of a particular item. Think about the differences you've seen over the years in the cost and quality of computers, calculators, cars or televisions. While we can quibble over the quantification of quality improvements, we should be able to agree that the roughly $2,400 I remember spending around 1984 for an Apple IIe computer would buy a lot more computing power today. (That Apple IIe had 256 kilobytes of RAM memory and NO hard drive at all!) Ditto for the $40 I spent in 1972 for a hand-held calculator (that basically just added, subtracted, multiplied and divided) versus what $40 can get you today in a calculator.

Because the BLS is focused on price inflation and not on quality improvements, they make quality adjustments to the prices of some of the goods and services they measure. They attempt to compensate for the increased quality in a product or service by offsetting from the price comparison the value of the quality improvements.

Hedonic Quality Adjustments

How they do this is really nerdy economic geek talk. They use something called "hedonic regression models" which quantify the value of various quality improvement factors.

Imagine the difference in monthly rent for a three bedroom apartment in downtown San Francisco versus Houston's suburbs. Then think of the various factors that might help explain the difference, including supply and demand, labor costs, property tax rates, land cost, etc. If you put a value on each of those factors, eventually you could explain most of the difference in what landlords can charge for rent in the two locations.

That's broadly what the BLS does when they find quality improvements in what they are measuring. They adjust the price of a particular good or service to take into account that the current good or service reflects quality improvements that the previously measured good or service didn't have.

"So, How Does That Impact Me?" 

What does this mean for us as consumers? Official measures of inflation don't necessarily reflect the actual prices we pay, but rather prices that are adjusted (typically downward) for quality improvements. It's not exactly the case, but think of it as the BLS telling us what the cost is today for a black & white, over-the-airways, big tube television, not what the cost is of a 65-inch LED 4k Smart TV.

Fortunately, or not, few of us are actually buying old black & white TVs. So, we enjoy higher quality goods and services--but just "keeping up with inflation" likely means that our budget is being squeezed. Actual out-of-pocket living costs are probably outpacing official estimates of inflation. That's especially true for those on fixed incomes, or even for those receiving quality-adjusted Cost of Living Adjustments in their Social Security checks.

And that, friends, is why even though inflation is low, some things are expensive.

Part Two – Next Month

Next month, we'll take a deeper dive into what investors should be doing and thinking about inflation. Stay tuned.

 

Notes:

This blog was inspired by an article appearing in Advisor Perspectives on March 18, 2019, entitled "Why Reported Inflation is So Low," by John H. Morse.  See:

https://www.advisorperspectives.com/articles/2019/03/18/why-reported-inflation-is-so-low?bt_ee=bIE7HlkcgFuepNo86AY7EMXU8Kt%2BetJLxZVmw6wT9kaFzWAoMzbDwH943bOjCokn&bt_ts=1552989882120

An example of how the BLS adjusts prices for quality improvements can be found at:

https://www.bls.gov/cpi/factsheets/telecommunications.htm

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