The Merriam-Webster dictionary defines inflation as a continuing rise in the general price level, usually attributed to an increase in the volume of money and credit relative to available goods and services. Why do we measure inflation?
As consumers, we need to have wages rise at the rate of the prices of the goods and services we consume, lest our standard of living decline. Therefore, to consumers, the best measure of inflation is one that accurately portrays the increased cost to maintain the current standard of living.
The two most widely used measures of inflation in the U.S. are the Consumer Price Index, or CPI, and the Implicit Price Deflator for Personal Consumption Expenditures, or PCE. The CPI is widely recognized, and is reported both as core CPI and without food and energy prices. The PCE is used in the computation of gross domestic product and is also reported sans food and energy.
Reported annual inflation is currently less than 2 percent. A person on the street may disagree that the cost of living is up only 2 percent in the last year. The disconnect between the actual increase in dollars we spend year over year and the measured inflation rate is due to the measurement process.
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For instance, housing prices are not used in computing the CPI. Instead, the Bureau of Labor Statistics uses an owner’s equivalent rent of primary residence. Shelter inflation is the change in equivalent rental prices year over year. Even if rental prices were to track housing prices, the measure would not account for the burden of an increased down payment.
Another issue is the use of a “hedonic quality adjustment.” This adjustment is designed to capture the increased functionality of technology devices year over year. The easiest example is a smartphone. Each year a new $500 phone has more computational power, and as a result is deflationary in the computation. Additionally, when you traded in your “dumb” phone, the additional cost for the smartphone and the required data plan were not captured in the measure.
Effectively, our standard of living is growing faster than the difference between wages and measured inflation. However, the individual who suffers from this lack of concise measurement is the retiree whose income increases are based upon this figure.
Kevin Jones, a chartered financial analyst, is principal at Harmonic Investment Advisors in Boise. firstname.lastname@example.org