Consumer price inflation

Government statisticians reported earlier today that U.S. consumer prices (CPI) fell a second straight month during May. Over the past 12 moths consumer inflation has been running at a 2% pace.

The so-called core rate of consumer inflation--the CPI minus volatile food and energy--is up 0.9%. In essence, consumer inflation is non-existent and that's good news. It relieves pressure on the Federal Reserve to raise rates and reassures investors that neither a steep rise in prices or a sudden drop in prices is imminent.

After all, a key measure of the economy's health is what's happening to the overall price level.

Here's why. What will a dollar be worth in a year, 5 years, 10 years from now? Trusting that a dollar will hold its value--that a dollar today will still be worth a dollar in a year or in ten years encourages us to do all kinds of good things, such as saving and investing. And vice versa, of course.

Statisticians at the Bureau of Labor Statistics calculate the consumer price index by tabulating price quotes on about 80,000 goods and services collected in 87 urban areas and from some 23,000 retail and service businesses. Data on rents come from 50,000 landlords or tenants.

The numbers are adjusted in mathematically sophisticated ways to come up with an index. Still, the CPI does have it flaws.

For one thing, taking quality improvements into account isn't easy. It's not that difficult to compare price changes of books, for example. A copy of Adam Smith's The Wealth of Nations, published in 1776 still looks pretty much the same today. He'd still recognize it as his book. But some products change a lot. A digital camera is a camera, but its really different from an old Kodak or even a Nikon SLR.

The CPI struggles to incorporate the impact of new technologies that attract a lot of consumer dollars and affect our quality of life, such as personal computers, cell phones, and MP3 players.

There's more. Another issue is called substitution bias. The CPI assumes that what we buy doesn't change much. Hah! We all tend to buy less of an item that is rising in price and more if prices are falling. A classic example is going to the supermarket and loading up on chicken when the price of meat goes up, or filling the basket with apples rather than oranges because apples are suddenly cheaper.

Let me add one more layer of complexity. It's called outlet bias. It simply means we shop at different stores than before. When I started buying CDs in the early 1990s I'd go to a record store. By the late 1990s, you could buy CDs on the cheap at big discount stores. Guess where more and more people bought their CDs. But now we download them.

Nevertheless, despite all these problems the CPI is pretty decent measure of the overall price trend. Even better you can get a market-based measure of inflation expectations using Treasury Inflation Protected Securities (TIPS). The yield on TIPS is forecasting that the rate of inflation will be slightly under 2% over the next 5 years and a fraction above 2% over the next 10 years.

Of course, many economists and investors worry about high and rising inflation in the future. Not now, but perhaps in a year or two. Their fear is that inflation will follow the enormous efforts Washington made to stave off a depression over the past two years. The inflation-is-coming crowd is making a huge bet on gold, a traditional haven against the ravages of inflation. The yellow metal closed at $1247.2 on the Comex on June 17, 2010--up about 25% over the past year.

What's the big deal with changes in the overall price level? Not much if the price changes are modest, up 1 or 2 percent, down 1 or 2 percent (that's called deflation). But history shows that society starts breaking down when trust in money deteriorates. In a sense, the inflation rate and the deflation rate is a barometer of the economic and social health of a nation. Both are bad at the extremes.

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