For years the Federal Reserve and many other central banks around the world have declared that a key element of monetary policy is the targeting of a two percent rate of annual price inflation. Now the Federal Reserve has suggested that that target rate may be “temporarily” raised to – well, they have been less precise about that.
As measured by the Consumer Price Index (CPI), prices in general have been increasing for most of the last ten years at well below two percent. Even “core” price inflation – that is, the CPI minus energy and food prices – has been below the two percent target rate for most of this time.
But in February 2017, the overall CPI increased at 2.7 percent at an annualized rate, and the “core” CPI was 2.2 percent higher. An alternative index – Personal Consumption Expenditures – that Fed Chair, Janet Yellen, and some other Fed Board Governors prefer to watch was up almost to two percent, as well, in February.
To begin with, it is worth observing that even if average CPI price inflation were to be kept at rate of two percent a year, in less than twenty years, the value of the dollar will have decreased by about 50 percent. That is, the buying power of today’s CPI-measured dollar would only get you an equivalent of 50 cents worth of similar goods in less than two decades.
But more fundamentally, any price index, whether the CPI or the PCE, are statistical constructions created by economists and statisticians that have very little to do with the actions and decisions of consumers and producers in the everyday affairs of market demand and supply. And are false guides for central bank monetary policy.
Overall vs. “Core” Price Inflation
The government’s CPI statisticians distinguish between two numbers: the change in the overall CPI, which as we saw increased at an annualized rate of about 2.7 percent in February and “core” inflation, which is the rate of change in the CPI minus food and energy prices, which rose 2.2 percent in February.
The government statisticians make this distinction because they argue that food and energy prices are more “volatile” than many others. Fluctuating more frequently and to a greater degree than most other commonly purchased goods and services, they can create a distorted view, it is said, about the magnitude of price inflation during any period of time.
The problem is that food and energy costs may seem like irritating extraneous “noise” to the government number crunchers. But to most of the rest of us what we have to pay to heat our homes and put gas in our cars, as well as buying groceries to feed our families, is far from being a bothersome distraction from the statistical problem of calculating price inflation’s impact on our everyday lives.
Constructing the Consumer Price Index
How do the government statisticians construct the CPI? The Bureau of Labor Statistics (BLS) surveys the purchases of 7,000 households across the country, which is taken to be “representative” of the approximately 325 million people living in the United States. The statisticians then construct a representative “basket” of goods reflecting the relative amounts of various consumer items these 7,000 households regularly purchase based on their buying patterns. The BLS monthly records changes in the prices of these goods in 24,000 retail outlets out of the estimated 3.6 million retail establishments across the whole country.
This is, then, taken to be a fair and reasonable estimate – to the decimal point! – about the cost of living and the rate of price inflation for all the people of the United States.
Due to the costs of doing detailed consumer surveys and the desire to have an unchanging benchmark for comparison, this consumer basket of goods is only significantly revised about every ten years or so.
This means that over the intervening time it is assumed that consumers continue to buy the same goods and in the same relative amounts, even though in the real world new goods come on the market, other older goods are no longer sold, the quality of many goods are improved as the years go by, and changes in relative prices often result in people modifying their relative buying patterns.
The CPI vs. the Diversity of Real People’s Choices
The fact is there is no “average” American family. The individuals in each household (moms and dads, sons and daughters, and sometimes grandparents or aunts and uncles) all have their own unique tastes and preferences. This means that your household basket of goods is different in various ways from mine, and our respective baskets are different from everyone else’s.
Some of us are avid book readers, and others just relax in front of the television. There are those who spend money on regularly going to live sports events, others go out every weekend to the movies and dinner, while some stay more at home and save their money for exotic vacations.
A sizable minority of Americans are still cigarette smokers, while others are devoted to health foods and herbal remedies. Some of us are lucky to be “fit-as-a-fiddle,” while others unfortunately may have chronic illnesses. Tastes, circumstances and buying patterns are as diverse as the 325 million people who live in the United States.
Looking Inside the Consumer Price Index
This means that when there is price inflation (or deflation) those rising (or falling) prices impact on each of us in different ways. Let’s look at a somewhat more detailed breakdown of some of the different price categories hidden beneath the CPI aggregate of prices as a whole.
In the twelve-month period ending in February 2017, food prices as a whole in the CPI rose zero percent, a seemingly stable price environment for food shopping. In fact, many food prices actually decreased over the previous 12-month period, according to the BLS. Meat, poultry, fish and egg prices decreased, together, by minus 3.3 percent. But when we break this aggregate down, we find that beef and veal prices declined by minus 4.4 percent and frankfurters went down minus 5.3 percent, while lamb and mutton, decreased by minus 7.0 percent. Chicken prices declined by minus 3.3 percent.
However, fresh fish and seafood were 5.5 percent higher than a year earlier. Milk was up 0.4 percent in price, but ice cream products increased by 2 percent in price over the period. Fruits, on the other hand, decreased by minus 4.3 percent at the same time that fresh vegetable prices declined by minus 7.2 percent.
If, instead, you were eating away from home in various types of establishments, the cost of eating out increased by 2.4 percent over the year. It would not be surprising if some individuals and families, therefore, ate at home more frequently compared to going out, given the fall in the prices of home-food ingredients versus paying for it to be prepared and served in restaurants.
Just as we might not be overly surprised that, while lamb and chicken prices both fell in the supermarket, the fact that lamb prices declined over fifty percent more than the price of chicken, this might lead some meat eaters to purchase and eat more lamb as part of a home-cooked meal than chicken, since the relative price of one had fallen significantly in terms of the other.
Under the general energy commodity heading, however, prices went up overall by 15.2 percent; but propane increased by 8.8 percent in price over the twelve-month period, while electricity prices, on the other hand, increased by only 1.9 percent. But gasoline for our cars was up by a huge 30.6 percent, and utility (piped) gas rose by 10.9 percent over the last year.
Counter-acting the rise in energy and fuel prices were furniture and bedding prices that decreased by minus 1.4 percent, and major appliances that declined in price over the period by minus 4.6 percent. New televisions went down a significant minus 20.1 percent over the year.
But at the same time, men’s apparel went up 2.2 percent over the twelve months, but women’s dresses rose a significantly higher 5.4 percent in the same time frame. While boys and girls footwear decreased by minus 0.7 percent.
Medical care services, in general, rose by 3.4 percent, but inpatient and outpatient hospital services increased, respectively, by 3.9 percent and 4.3 percent. Prescription drug prices rose, on average, by 5.2 percent and physicians’ services increased by 3.6 percent between February 2016 and February 2017.
Smoke and Mirrors of “Core” Inflation
These subcategories of individual price changes highlight the smoke and mirrors of the government statisticians’ distinction between overall and “core” inflation. We all occasionally enter the market and purchase a new stove or a new couch or a new bedroom set. And if the prices for these goods happen to be going down or not rising very much we may sense that our dollar is going further than, perhaps, in the past as we make these particular purchases.
But buying goods like these is an infrequent event for virtually all of us. On the other hand, every one of us, each and every day, week or month are in the marketplace buying food for our family, filling our car with gas, and paying the heating and electricity bill. The prices of these goods and other regularly purchased commodities and services, in the types and combinations that we as individuals and separate households choose to buy, are what we personally experience as a change in the cost-of-living and our personal rate of price inflation (or price deflation).
Individual Prices Influence Choices, Not the CPI
The Consumer Price Index is an artificial statistical creation from an arithmetic adding, summing and averaging of thousands of individual prices, a statistical composite that only exists in the statistician’s calculations.
It is the individual goods in the subcategories of goods that we, the buying public, actually confront and pay when we shop as individuals in the market place. It is these individual prices for the tens of thousands of actual goods and services we find and decide between when we enter the retail places of business in our daily lives. And these monetary expenses determines for each of us, as individuals and particular households, the discovered change in the cost-of-living and the degree of price inflation (or deflation) we each experience.
The vegetarian who is single and without children, and never buys any types of meat, has a very different type of consumer basket of goods than the married couple who have meat on the table every night and shop regularly for clothes and shoes for themselves and their growing kids.
The individual or couple who have moved into a new home for which they have had to purchase a lot of new furniture and appliances will feel that their real (or buying power) income has gone down a bit over the past twelve months compared to the person who lives in a furnished apartment and has no need to buy a new chair or a dishwasher but eats beef or veal three times a week.
If the government were to impose a significant increase in the price of gasoline in the name of “saving the planet” from carbon emissions, it will impact people very differently depending up whether an individual is a traveling salesman or a truck driver who might have to log thousands of miles a year as part of their job, compared to a New Yorker who takes the subway to work each day, or walks to his place of business.
It is the diversity of our individual consumer preferences, choices and decisions about which goods and services to buy now and over time under constantly changing market conditions that determines how each of us are influenced by changes in prices, and therefore how and by what degree price inflation or price deflation may affect each of us.
As American economist, Benjamin Anderson, pointed out long ago,
The general price level is, after all, merely a statistician’s tool of thought. Businessmen and bankers often look at index numbers as indicating price trends, but no businessman makes use of index numbers in his bookkeeping. His bookkeeping runs in terms of the particular prices and costs that his business is concerned with…. Satisfactory business conditions are dependent upon proper relations among groups of prices, not upon any average of prices.
Indeed, as Austrian economist, Gottfried Haberler, also long ago highlighted, “The relative position and change of different groups of prices are not revealed, but are hidden and submerged in a general [price] index.” Yet, it is what is happening in the complex and interconnected structure of the relative prices for finished goods and the factors of production that influence and guide the market choices of consumers and the business investment and related decisions of entrepreneurs as to how best to direct production to serve the buying public in the pursuit of alternative profit opportunities.
Indeed, for many Americans in terms of their individual chosen baskets of goods during the previous 12 months based on the CPI price data, they might very well conclude they had been experiencing a period of general price deflation, while others could view themselves as having suffered from varying degrees of general price inflation.
Monetary Expansion Distorts Prices in Different Ways
An additional misunderstanding created by the obsessive focus on the Consumer Price Index and similar price aggregates is the deceptive impression that increases in the money supply due to central bank monetary expansion tend to bring about a uniform and near simultaneous rise in prices throughout the economy, encapsulated in that single monthly CPI number.
In fact, prices do not all tend to rise at the same time and by the same degree during a period of monetary expansion. Governments and their central banks do not randomly drop newly created money from helicopters, more or less proportionally increasing the amount of spending power in every citizen’s pockets at the same time.
Newly created money is “injected” into the economy at some one or few particular points reflecting into whose hands that new money goes first. In the past, governments might simply print up more banknotes to cover their wartime expenditures, and use the money to buy armaments, purchase other military supplies, and pay the salaries of their soldiers.
The new money would pass into the hands of those selling those armaments or military supplies or offering their services as warriors. These people would spend the new money on the particular goods and services they found desirable or profitable to buy, raising the demands and prices for a second group of prices in the economy. The money would now pass to another group of hands, people who in turn would now spend it on the market goods they wanted to demand.
Step-by-step, first some demands and some prices, and then other demands and prices, and then still other demands and prices would be pushed up in a particular time-sequential pattern reflecting who got the money next and spent it on specific goods, until finally more or less all prices of goods in the economy would be impacted and increased, but in a very uneven way over time.
But all of these real and influencing changes on the patterns of market demands and relative prices during an inflationary process are hidden from clear and obvious view when the government focuses the attention of the citizenry and its own policy-makers on the superficial and simplistic Consumer Price Index and other similar statistical price aggregates.
Money Creation and the Boom-Bust Cycle
Today, of course, virtually all governments and central banks inject new money into the economy through the banking system, making more loanable funds available to financial institutions to increase their lending ability to interested borrowers.
The new money first passes into the economy in the form of investment and other loans, with the affect of distorting the demands and prices for resources and labor used in capital projects that might not have been undertaken if not for the false investment signals the monetary expansion generates in the banking and financial sectors of the economy. This process sets in motion the sequence of events that eventually leads to the bust that follows the inflationary bubbles.
Thus, the real distortions and imbalances that are the truly destabilizing effects from central banking inflationary monetary policies are hidden from the public’s view and understanding by heralding every month the conceptually shallow and mostly superficial Consumer Price Index.
