The myth of low inflation

Wayne Farlow //October 21, 2010//

The myth of low inflation

Wayne Farlow //October 21, 2010//

The Federal Reserve continues to fret over low inflation rates and how this could lead to deflation. While the Fed claims that we have virtually no inflation, my recent personal experience has been just the opposite. The cost of living, especially the cost of food, energy and health care, appears to be rising at rates that were last seen in 1981.

To understand this apparent dichotomy, let’s take a look at how the Consumer Price Index (CPI) is calculated.

The CPI is calculated by examining monthly price changes in eight different categories of consumer expenditures. Each category is assigned a “weight” based on the government’s estimate of what the “average” consumer spends in each category. The following table provides each category of expenditures as well as the percentage weighting, assigned by the Bureau of Labor Statistics. The right hand column provides an alternative weighting for a “hypothetical consumer” with lower housing costs. This could be a consumer that has paid off their mortgage or remained in the same house for many years.

Expenditure category          CPI-U Hypothetical          Average Consumer
—————————-
Food and beverages                    15.7 percent                 25 percent
Housing                                      40.9 percent                 10 percent
Apparel                                         4.4 percent                   5 percent
Transportation                            17.1 percent                 20 percent
Medical care                                  5.8 percent                 25 percent
Recreation                                     6.0 percent                   4 percent
Education and communication      5.8 percent                   3 percent
Other goods and services              4.3 percent                   8 percent
—————————-
Total, all items                          100.0 percent            100.0 percent

If you are interested in exploring the CPI in more detail, this information can be found at http://www.bls.gov/news.release/cpi.t01.htm

The CPI data supplied by the Bureau of Labor Statistics accurately shows that, with the current governmental category weightings, the CPI increase over the past twelve months is only 1.1 percent. However, looking at the increases by expenditure category shows that transportation costs rose 4.6 percent and health care costs are up 3.4 percent over this time frame.

The large increases in transportation and medical care costs are offset by housing costs, which are given a weight of 41 percent of the total CPI basket. The CPI data shows that housing costs decreased by 0.3 percent over the past year. However, unless a home was refinanced or one moved into a smaller residence, most people’s housing costs have increased over the past year due to higher energy prices, property taxes etc.

Since recent costs increases appear to be accelerating, we examined CPI change data that is also available for the past three months. Using the government provided CPI average weighting and annualizing the data by expenditure category over the last three months, we calculate the current three month “run rate” for the CPI increase as 2.7 percent, instead of the past year’s 1.1 percent.
To further test the CPI data, using the published annual CPI increases by expenditure category, we calculated the annual CPI change with the category weightings of the “hypothetical” consumer. When the “hypothetical” consumer expenditure weightings are used, the inflation rate over the past twelve months doubles to 2.2 percent.

Finally, we calculated the “hypothetical” consumer expenditure weightings combined with the current “run rate” of inflation. When the hypothetical consumer weightings are applied to the government supplied CPI data over the past three months, the annualized rate of inflation for our “hypothetical” (but realistic) consumer was a startling 4.0 percent.

Quantitative Easing Two, due to be announced at the November Fed meeting, will add vast amounts of cash to our economy. The justification for this program is that our inflation rate is so low that the government needs to increase our rate of inflation. Would that reasoning be acceptable if the current inflation rate is 4 percent?

The next time you are paying for groceries, your utility bill or your health insurance, you might discover that you are more like our “hypothetical” consumer whose inflation rate is running at several times the government provided CPI rate. We can only hope that the Fed changes directions before our inflation rates match those last experienced in 1981.

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