Why some analysts believe the Consumer Price Index formula understates inflation while others believe the CPI formula overstates inflation. What really matters to us individually when it comes to inflation.
In this podcast episode you’ll learn:
- What is inflation and what causes it.
- How is the Consumer Price Index calculated and how has the CPI formula changed over time.
- What are examples of different CPI measures?
- Why do some analysts believe U.S. inflation is higher than what CPI states while others believe inflation is lower than what the Consumer Price Index shows.
- How inflation calculations impact the measurement of other economic data such as the rate of poverty and the growth in real wages.
- What are consumer attitudes toward inflation and why do central banks worry about changes in household and business inflation expectations.
- How individuals can monitor and improve their cost of living.
We know that inflation is the rise in prices over time, but what causes inflation and how is it measured? In this episode, David Stein explains the calculations behind the statistics and the controversies surrounding the accuracy of inflation measurements. Listen to the entire episode for examples of inflation measurement within both the U.S. and globally, and why subjectivity may play a larger part than you might think.
How is inflation measured?
Inflation occurs when the amount of money in the economy increases at a faster rate than the number of goods and services available to purchase, pushing up prices. While excess money is generally created by bank loans, businesses are the ones that actually generate inflation by raising their prices.
In the U.S., inflation is measured by the Bureau of Labor Statistics (BLS) through the Consumer Price Index (CPI). The CPI represents all of the goods and services purchased. David’s focus in this episode is the CPI-U measurement, which represents all of the household and business purchases. The collection of represented goods and services used to calculate inflation is known as the “reference basket.”
The controversy: understated inflation vs. overstated inflation
What should go into the reference basket used to calculate the CPI? In the past, the goods and services included were not changed, but now the Bureau of Labor Statistics endeavors to represent current consumer trends. The controversy is whether or not inflation is being measured according to the perceived standard of living or being measured according to the rise or fall in the price of goods and services.
Some believe that inflation is understated and that the contents of the reference basket should remain the same and provide a consistent standard for consumers to measure their spending and standard of living against. When calculated according to a fixed-basket measurement, inflation runs approximately 2% higher than official inflation statistics.
Others believe that inflation is overstated because the BLS doesn’t capture many of the quality improvements found in certain products. The price of a good might be higher than it was, but if the higher price is because the product is better or has additional features then that should be reflected in inflaton measures by showing a smaller price increase since much of the rise was due to an improved product.
Governments often play a large role in inflation measurement
David explains that governments are concerned about measuring inflation for three reasons:
- People believe that inflation strongly affects their everyday lives.
- People dislike inflation and view it as a vehicle for greed—no matter how low it is.
- People tend to associate inflation with negative economic trends.
While governments try to accurately display the rate of inflation, they often realize that it is a subjective measurement, which can lead to different conclusions regarding the state of the economy.
For example, David explores the case of Rwanda and Paul Kagame’s governmental statistics concerning the health of the Rwandan economy. According to the numbers, poverty fell 7% from 2011-2017 while the economy grew 8% on an annual basis. 38% of the populace is still considered to reside in poverty. There is controversy concerning the numbers given, however, with many believing that the Rwandan government has not accurately measured their inflation, given the change in consumer practices, geography, and the rise and fall in prices. Some calculate that inflation is actually much higher, and that poverty has actually increased because the standard of living has not been taken into account while measuring the CPI.
How can you increase your standard of living without spending more money?
Inflation certainly exists. If we look back at the standard of living of a middle-class family in 1998, we’ll find that it is much higher than the standard of living of a family living off of the same income today. How much of the influence of inflation do we have control over, however? Are there ways that we can mitigate its effect on our standard of living? Tracking spending habits can be hugely helpful when determining where one garners value. What determines your standard of living? What is satisfactory to you? What could you live without or spend less on without sacrificing quality?
The subjectivity surrounding the standard of living and what goes into our personal reference baskets makes calculating inflation difficult. Considering the subjectivity of the contents within the CPI, inflation is most likely being calculated with the greatest accuracy possible.
- [0:18] Traditional methods of measuring inflation.
- [4:00] The CPI has changed from a fixed-basket approach to a consumer-representative approach.
- [6:39] The controversy concerning the accuracy of CPI measurement.
- [9:11] Is inflation overstated because of how the CPI-U is calculated?
- [11:23] Rwanda case study: the connection between inflation and poverty.
- [15:17] Why governments care so greatly about the public’s view of inflation.
- [17:31] How inflation expectations are measured.
- [18:52] How do we calculate the desired standard of living?
- [20:41] The CPI isn’t an accurate depiction of the standard of living.
- [24:20] Are you satisfied with how you spend your money?
Would you like to read more about inflation? Check out The Ultimate Guide to Understanding and Protecting Against Inflation.
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