cpi

Watch Out for Surge in CPI

Philip Brewer — Thu, 16 Jul 2009 17:00:08 +0000

Just to be clear, I'm also worried about a surge in inflation, but that's not what I'm talking about here. I don't know the future, so I try to stay away from predictions. But you don't need to know the future to "predict" a surge in the Consumer Price Index. All you need is to know the recent past.

I distinguish between inflation and the CPI. Inflation is the money becoming less valuable. The Consumer Price Index is an indicator of recent prices based on the prices of a standard basket of consumer goods.

The CPI is just a number. The number for June (reported July 15th) was 215.693 (versus a base of 100 in 1983).

Most people, though, don't really care about the number--they care about changes. And that makes sense--rising CPI values are an indication of rising prices, and rising prices are an indication of inflation.

(As an aside, rising prices don't necessarily mean inflation. Lots of things, such as changes in styles, tastes, and consumer preferences can change relative prices. Some things, such as taxes, technological change, and resource depletion, can change absolute prices. But none of those things are inflation, even if they result in rising prices.)

Almost all the attention to the CPI focuses on two things:

The change from last month
The change from last year

And it's that second one that prompts me to warn of a surging CPI.

After peaking in July last year, energy prices fell for months. From July 2008 to March of 2009, energy prices fell 37%. (Data from Bureau of Labor Statistics.) Energy prices amount to about 7.5% of the index, so that fall, all by itself, has had the effect of subtracting something like 3 percentage points from the overall CPI change from a year ago.

The thing is, most of the recent fall occurred in the last three months of last year. In the CPI index values published in the coming November, December and January, those big declines will "drop off" the year-ago comparisons--which will produce the surge I'm talking about. The "change from a year ago" values reported for the CPI for those months is going to be much higher--pretty much regardless whether there's any inflation.

Does it matter? Well, it matters to some people--people who invest in TIPS, for example, care a lot about the reported value of the CPI. (People on Social Security also care a lot, but as it happens the base year for figuring Social Security cost of living adjustments ends in September, so the effect of this spike won't show up until 2011.)

In fact, though, what really matters to real people is how their own cost of living changes.

I just wrote a post making fun of another economist's prediction of inflation, so I want to be really clear about the distinction here: What I'm talking about is a statistical artifact of the way the CPI gets calculated. For the past year, falling energy prices have made the inflation numbers look artificially low. For the next few months, CPI calculations of "changes from a year ago" is going to show inflation numbers that are artificially high--even if the value of the money were stable, we'd still see a spike in the CPI simply because the base month for comparison is going to have lower and lower fuel prices.

Last October I wrote a post called Inflation is going away for a while. Despite my general reticence about making predictions, things seemed clear enough to risk that one. This post is my official announcement that "a while" is just about over.

With that in mind, I'll direct you to a post of mine from earlier last year: How to live with inflation. Everything old is new again.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Oh noes! Inflation!

Philip Brewer — Fri, 12 Jun 2009 08:39:45 +0000

The Wall Street Journal has an opinion piece by Arthur Laffer that shows a scary graph of the monetary base, which has surged enormously in the past year. He suggests that this is "potentially far more inflationary" than the monetary policies of the 1970s. I'm as worried about inflation as anybody, and agree that the Fed should already be taking steps to minimize it, but I think Laffer is off-base here.

Here's a graph much like the one in the Wall Street Journal opinion piece, showing the recent spike in the monetary base. You can see a couple of earlier, much smaller spikes when the Fed took action in advance of Y2K and after 9/11. Scary, no?

Except, here's a view of changes in the monetary base from 1984 to mid-2008 (i.e. until the recent spike), together with CPI inflation over the same period. Notice a strong correlation between changes in the monetary base and future inflation? No? Me neither.

Okay, here's another. This is the M2 money supply versus CPI inflation from 1984 through mid-2008. To my eye, that at least shows some correlation--the money supply rises before inflation heats up and then drops when inflation drops. The correlation doesn't look so hot from 1995 through 2005, but we are starting to get a better picture of what happened then--the excessive money supply growth pumped up asset prices (the dotcom bubble), while globalization held down consumer prices.

So, what does that tell us? Maybe not a lot. But, if M2 money supply is of at least some use for prediction future inflation, here's another look--the same graph, but this time running up to the latest data available. The CPI rate has plummeted--the year-over-year change in prices actually going negative due to the combination of falling fuel prices, the financial collapse, and the recession. But look at M2--the rate of change there is hardly unprecedented. We saw similar spikes in the mid-1980s and then again when the Fed eased monetary policy in the wake of the dotcom crash. That is liable to lead to some inflation, but it's an ordinary risk of an ordinary rate of inflation--not some huge hyperinflationary catastrophe.

Now, I don't want to minimize the dangers of the surge in the monetary base. If that potential for money creation is realized as actual growth in the money supply, then we can kiss the dollar good-bye. But although the surge is unprecedented in its magnitude, there's actually a good example of the Fed managing a monetary-base spike without producing a catastrophe--the results of their actions in the run-up to Y2K.

Concerned that the Y2K bug might take down the computers that ran the ATMs, the banks, and the communications networks that connected the banks, the Fed made sure that there was extra cash in the hands of the banks and extra reserves in the banking system, just in case. Then, when it turned out that nearly everyone had fixed all their important Y2K bugs, they drained the excess reserves. Here's a close-up of the monetary base and CPI during that period, showing no sign of wild swings in prices. That's not proof that we won't have a huge inflationary spike, but it does show that it's at least possible to have large swings in monetary base growth without adverse impact on prices.

I'm worried about inflation too; I just don't think the scary monetary base graph is the reason to be scared.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Roll your own cost-of-living index

Philip Brewer — Thu, 15 Nov 2007 20:38:06 +0000

If you have a budget--more specifically, if you track your spending--you have the data you need to track changes in your own personal cost of living. That's a lot more useful than the Bureau of Labor Statistics Consumer Price Index (although people on Social Security, or with a lot of money invested in inflation-indexed treasury bonds, care about the CPI too). It's not so easy to turn your data into a number, though. In fact, you'll face a lot of the same problems the government does.

The first thing to do is to think about what you're really trying to get at. If all you wanted to know was your cost of living, you could calculate that pretty easily. If you're tracking your spending, it's right there--the sum of all your spending. Even if you're not, you can come pretty close: Add up all your income, subtract out any money that went into savings or investments, and the difference is, more or less, what you spent.

Usually, though, you're trying to figure out something slightly more subtle. What you want to know is, am I getting ahead, or am I falling behind? Am I spending more because my standard of living has gone up, or am I spending more because the money is worth less?

In some cases, it's easy to decide. If you stayed in the same apartment, and your rent went up by 3%, that's probably almost all higher cost of living. (The exception would be if the apartment had been improved in some way, such as by swapping our your old refrigerator for a new energy-efficient model.)

In other cases, it can take thoughtful consideration and some careful calculation. Suppose your grocery bill is up by 7%. There's almost no way to know what that means in terms of your cost of living, unless you've kept accurate notes about things like how often you ate out and how often you fed other people. A 7% increase in your grocery bill could amount to a drop in your cost of living if you cooked one extra meal a week instead of eating out. It would be a huge drop if you went from feeding two people to feeding three with only a 7% increase in cost.

Basically, you're running into the same problems the government does. It calculates the CPI based on a standard "basket" of goods and services. That allows them to avoid the household size issues, but it has plenty of its own problems.

What goes in the basket?

Simply for practical reasons, the CPI price basket can't include everything anyone might buy. Government economists pick a basket with a reasonable number of items, trying to pick things that a good indicators of a whole class of items.

One classic issue is "substitution"--as items become more expensive, consumers buy less of that and more of something that's cheaper. If the basket were to simply follow what people buy, it would miss some of the rise in the cost of living. On the other hand, if something that used to be a standard item (let's say, hardwood molding, cut in a particular scallop pattern), is kept in the basket even after it becomes a speciality item, the price changes in that item reflect other things than changes in the cost of living.

The government has economists and bureaucrats trying to balance those trends. You have the advantage of being able to look at what you actually spend.

What's the price?

There are plenty of items that are always on sale, in some form. At many stores, for example, there is always one brand of soda on sale, always one brand of premium orange juice on sale, etc. Consumers who are price sensitive--and consumers who plan ahead and stock up--can always buy the one that's on sale. CPI data, though, is for specific items and is gathered at a specific time. Sale prices probably average out over time, but they may not, and they definitely introduce noise into the system.

There's also the issue of changes in where people shop. How much of the CPI should be based on the prices at WalMart, and how much should be based on the price at the little hardware store downtown?

Again, you don't have to worry about these issues, because you can calculate your personal CPI on what you actually spend, where you actually spend it.

Other issues

There are plenty of other issues that keep it from being a trivial exercise to calculate your own personal cost-of-living index.

Boundary cases--If some years you pay a bill in late December and other times you pay it in early January, you'll have some years that you don't pay it and other years that you pay it twice. That doesn't mean your cost of living is bouncing around.

Major purchases--If you bought an expensive flat-screen TV last year, but didn't buy another one this year, your "household goods" category might show a 50% drop, but it's hard to say just what that means in terms of your cost of living.

Gifts--What you pay for gifts that you give is probably part of your cost of living, but it's harder to decide how to handle gifts that you receive.

Worth doing

In the greater scheme of things, though, it almost doesn't matter how you decide to handle these sorts of special cases, because the results will be useful in any case.

If you go through the exercise, you'll definitely learn some things. If you just go with your overall impression, as opposed to actually cranking the numbers, it's easy to over-emphasize changes in the prices that are highly visible (gasoline, for example). Contrariwise, you're likely to under-emphasize price changes in things that seem to be bargains (even if it's still cheap, a 15% increase in the price of peanut butter is a 15% increase).

The Bureau of Labor Statistics released their consumer price index today. It was up 0.2% last month, up 3.5% from a year ago.

If any of you calculate the change in your cost of living, I'd be very interested to hear what numbers you come up with.

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: