Measures of inflation are probably very wrong.

Economists suggest that increases in nominal income partially reflect higher prices for goods and services, a phenomenon more commonly known as inflation.  Wikipedia defines inflation as,

a sustained increase in the general price level of goods and services in an economy over a period of time resulting in a loss of value of currency.

You can pretty easily find estimates of common purchasing power indices online to examine the portion of your income growth that is actually fake.  According to the CPI-U, for example, reasonable people would be indifferent between purchasing $60,000 of 2015 goods and services at 2015 prices, $34,000 of 1990 goods and services at 1990 prices, $20,000 of 1980 goods and 1980 prices, and $11,000 of 1970 goods and 1970 prices.  Most reasonable people, of course, would not be anywhere close to indifferent about these choices.

In 1970, the median income was about $4,000 – so $11,000 sounds pretty good.  In a “competing for fixed resources compared to the median” sense, $11,000 in 1970 would be like $165,00 today.  The difference between earning $165,000 and $60,000 today is nothing close to the difference between earning $60,000 today and $11,000 in 1970.  Access to bigger houses in better cities, slightly better healthcare, fine dining, and cashmere sweaters is many orders of magnitude less valuable than improvements in health technology that have dramatically increased the quality of the last-quarter of life, ubiquity of high quality entertainment, explosive growth in consumer choice, and safer working conditions for the people that make all of the above possible.

This effect isn’t just a result of the long time that has passed in my example above.  According to the same measure, $45,000 in 2002 is similar to $60,000 in 2015.  The median annual rent increased by about $3,000 over this time.  Food prices probably didn’t increase much, and even if they did, most people would probably rather eat at home more frequently if it meant access to 2016 stuff instead of 2002 stuff.  In fact I would find it totally reasonable if people would rather earn $45,000 today than $45,000 in 2002, suggesting that it is at least reasonably possible that the Federal Reserve’s most important measure has a margin of error greater than 100 percent.

Even if this insane effect was a result of inflation being inconsistent over time, it doesn’t matter.  Small increases in price level from year to year may be both correct and totally irrelevant – the only reason people care about inflation is long-term compounding effects that result in meaningful differences.  There is obviously a distributional component.  Inflation is probably quite a bit higher for very poor people that spend most of their money on fixed things like rent and for very rich people who can only direct income towards buying more beach houses or private jets than it is for the rest of us.  In particular, earning $4,000 in 1970 is probably better than earning $4,000 in 2015.

For this reason I find it amusing that there are economists at the Federal Reserve that are studying the question of whether to raise the cost of borrowing by 25 basis points this year or next based on changes in a measure which, in aggregate, is probably off by several orders of magnitude over any length of time that is relevant.  The answer to the secular stagnation paradox might be that we’ve had persistent deflation of over 1 percent since 1990.  The answer to Robert Solow’s famous and oft-repeated quip that “You can see the computer age everywhere but in the productivity statistics,” might be “the productivity statistics you’re using are clearly wrong.”

  1. Paul Carbone said:

    Interestingly, it’s difficult to get an accurate comparison of prices between today and 1970 even for many commodities. Gasoline (for example) today is unlikely to have lead in it, which is certainly a significant improvement, but this isn’t typically considered in a standard price-per-volume comparison over time.

  2. Dots said:

    That stuff is important for u smartypantses to know, but I feel people want to know transport, housing, telecom, medicine, taxes, uni, dependent care cost growth and if indices fail to measure product improvements or gizmo emergence so much the better. Hedonically-adjusting minds don’t incorporate it, either. ‘Maybe 5 years ago overdose-repairing drug sucked and was pricier but 5 years ago I wasn’t overdosing now I am!’ Etc

    Maybe I want the word ‘inflation’ to have fewer tenants

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s