Sunday, June 17, 2007

Cost of living increases and inflation are not really the same

The headline of the article by Jeremy Peters in The New York Times says "Cost of Gas and Food Rose Sharply Last Month" although the article does admit that "an important gauge of inflation drifted lower." Why the conflicting messages? The answer, as you might suspect, is that "it all depends." Literally, it depends on exactly what you want to measure and over what timeframe.

At a human emotional level, people respond very negatively to short-term price spikes, such as we saw with energy prices in May, but less emotionally to gradual rises over time and even pleasant price declines that may be as large as a previous price spike.

Another issue is that there is a huge difference between "cost of living increase" and "inflation." The former is a phenomenon of micro-economics, whereas the latter is a phenomenon of macro-economics. The former relates to how much money people have in their pockets and paychecks in the here and now, whereas the latter is of concern to economists over relatively long periods of time (but measured at annualized rates) and independent of short-term fluctuations.

One bizarre consequence of the difference between these micro-economic and macro-economic concerns is that in fact inflation might be relatively low over a period of time while consumers could be experiencing significant anguish over accumulated price increases that are causing them far more pain than any current inflation. In other words, consumers feel far more pain from past price increases than any satisfaction they might get that prices have actually improved in the past few weeks.

Macro-economists are not really concerned about price spikes in general since they frequently dissipate and even reverse over the medium term. These economists are concerned much more with the average over an extended period of time (quarters and years) than short-term effects (month to month.)

This is why macro-economists look at "core" inflation, since they do not care about transient price changes that don't feed back into core prices within the medium time scale.

Yes, consumers do "have to eat and buy gas", but macro-economics is about the big picture over an extended time scale, and they assume that food and energy prices will in fact moderate over time. The obvious paradox is that macro-economists are only looking at annual rates without looking at accumulated price increases over a number of years. 2% a year over ten years seems benign at a one-year interval but amounts to over 20% over a ten-year period. Or even a 1.5% annual rise which would be considered almost "ideal" by many economists still amounts to 15% over ten years or 30% over twenty years. It is ironic that macro-economists are trying to look at those one-year rates to get closer to the impacts on consumer spending patterns, when it is that accumulated impact on spending power that is causing the real pressure on consumers, over time.

The open question right now is the extent to which elevated energy prices of the past two years will increasingly feed back into core prices since firms which had "absorbed" such price increases in the hope that they would quickly reverse but haven't, so they will be increasingly under pressure to raise prices of everyday goods and services that are included in the core price index.

-- Jack Krupansky


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