David R. Henderson  

Inflation is Even More Inflated Than We Thought

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In his entry, "Consumer Price Indexes," in The Concise Encyclopedia of Economics, Michael Boskin concludes that the CPI overstates inflation by 0.8 to 0.9 percentage points annually. That doesn't add up over the years; it compounds up. Here's a key paragraph:

The CPI currently overstates inflation by 0.8-0.9 percentage points: 0.3-0.4 points are attributable to failing to account for substitution among goods; 0.1 for failing to account for substitution among retail outlets; and 0.4 for failing to account for new products. Thus, the first 0.8 or 0.9 percentage points of measured CPI inflation is not really inflation at all. This may seem small, but the bias, if left uncorrected for, say, twenty years, would cause the change in the cost of living to be overstated by 22 percent.

Now Peter Klenow of Stanford University and Huiyu Li of the Federal Reserve Bank of San Francisco have found a further source of upward bias in the CPI: failure to account correctly for new goods and services that replace inferior old goods and services. In "Missing Growth from Creative Destruction," they write:
Products such as electronics and apparel are particularly affected because their quality changes frequently. The BLS uses several methods to adjust for these changes. These methods, and the Boskin Commission's critique of them, focus on updates made by existing producers, or "incumbents," to their own products. But what happens when a producer is replaced by a different producer--for example, when a new restaurant forces a nearby restaurant out of business because customers prefer their menu?

When a product disappears without being replaced by a new version from the same producer in the same location, the BLS typically fills in or "imputes" the missing price and then starts tracking a new item. In particular, the BLS imputes inflation for the disappearing item to be the same as inflation for similar products that remain on the market. The BLS resorts to such imputation roughly twice as often as it directly estimates quality changes (Aghion et al. 2017).


By the way, they use the term "inflation" in the above quote in a way that is not normally used. Inflation typically refers to increases in the prices of goods and services in general, not an increase in the price of a particular good. But it doesn't undercut their point.

Here's the problem:

In doing such imputation, the BLS assumes the inflation rate is the same for changeovers from old to new producers as it is for all surviving items. This may not be an accurate assumption of the true values. Research since Schumpeter (1942) highlights growth driven by so-called creative destruction. Under creative destruction, new producers replace existing producers precisely because they introduce a product with a lower quality-adjusted price. The items that survive are those that do not experience creative destruction. Most of these surviving items have not been updated at all, according to the BLS. Hence, by using the inflation of surviving products to approximate the inflation rate of products that disappear, the BLS could be overstating the inflation rate of the disappearing products.

Read the whole thing, which is not long, for the rest of their reasoning.

Their bottom line:

Although the bias does not explain much of the sharp decline in productivity growth, its magnitude is economically significant--nearly 0.6% per year on average, or about one-fourth of true growth.

Moreover, they note one implication of their finding that undercuts a claim by Klenow's colleague Raj Chetty:
Measuring real growth properly is useful for addressing a host of questions. For example, existing studies use measured inflation to calculate the real income of children relative to their parents. Chetty et al. (2017) find that 50% of children born in 1984 achieved higher incomes than their parents at age 30. Adjusting for missing growth would raise the real income of children about 17% relative to their parents, increasing the fraction of those who do better than their parents by a meaningful amount. Thus, to the extent that inflation is overstated due to imputed values, a larger fraction of children appear to be better off economically than their parents. This improvement in economic welfare can shine a bit more positive light on current conditions, despite the gloom of slower productivity growth.

HT2 Jeff Hummel.


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COMMENTS (22 to date)
Conscience of a Citizen writes:

Klenow and Li work for the Federal Reserve, which generates inflation the old fashioned way: they print fiat money.*

Nevertheless, K&L tell us:

"When products disappear from the market with no substitutes from the same manufacturer, they may have been replaced by cheaper or better products from a different manufacturer."

K&L leave open, but carefully omit to mention, the possibility that those disappearing products also "may have been replaced" by more costly or worse products. As, for example, motor gasoline was (mostly) replaced by gasohol.

After elaborating on their happy thesis for a while, they write:

"Under creative destruction, new producers replace existing producers precisely because they introduce a product with a lower quality-adjusted price."

Or, the cynical reader immediately notes, because the new producers are more-effective rent-seekers, or because a product with a higher quality-adjusted price is more profitable for the oligopolists who dominate production in a given market. Sheesh, do K&L really expect us to accept that the quality-adjusted price of, say, cable-TV or state university tuition has been falling?

Articles like this make me sigh. I don't expect anything different from the Federal Reserve's minions, but I'm always disappointed to see econobloggers endorse the propaganda.

Scott Sumner's proposed alternate definition of "inflation" (which he doesn't believe in, but is willing to discuss) as consumers' perception that they can't keep up their standards of living without wage increases-- which they aren't getting-- offers some insight. The price of nearly everything I and the folks around me want to buy has been rising relentlessly, except the prices of smartphones and a few other gadgets. Man does not live by smartphone alone.

K&L repeat the remarkably insulting claim that there is no inflation because consumers suffer from a kind of false consciousness: they simply do not understand that the sometimes inferior, frequently more costly goods which they purchase, reluctantly and with many a muttered curse, to keep body and soul together, actually have "lower quality-adjusted prices." Butter is $3/lb. instead of $2? The quality must have gone up. A cotton shirt is $35 instead of $24 and lacks gauntlet buttons? That's obviously a "lower quality-adjusted price!" A one-bedroom apartment in a medium-nice neighborhood rents for $950/month instead of $600? Don't worry, along some utterly-imperceptible dimension the quality, or at least the "hedonic value" has increased. (Who knows? Maybe it did-- hedonic values are relative to anhedonic values and perhaps sleeping on a park bench is less appealing now, making sleeping in an apartment more appealing, so even if you have to pay a lot more to sleep in an apartment your dollars:utils ratio has actually improved!)

Give us a break.

*They do this to tax people covertly, to drive down real wages, and to enrich banks and financial firms.

Jason writes:

[Comment removed. Please consult our comment policies and check your email for explanation.--Econlib Ed.]

Alan Goldhammer writes:

@David Henderson - thanks for an interesting post and the links. As a Social Security recipient and Medicare consumer, I'm most interested in the CPI particularly at this time of the year when adjustments are announced (disclaimer - I am not reliant on Social Security for my 'inflated' standard of living as a retiree!).

I've seen some shows about how BLS workers go out and get prices to calculate the CPI and it's probably the best approach. As one who is compulsive about tracking expenses (Excel is my friend), I know what my cash outflows are on a yearly basis and can see where costs are rising. The relative weights in Table One in the Boskin article are informative but don't tell the whole story.

Medical inflation is quite significant and has a disproportionate effect as one gets older and requires more services in that area. Housing costs are difficult to deal with since moving to control costs is often difficult (living in an empty next house one consumes more energy than if one downsized to a smaller abode and costs increases have a more direct impact on the bottom line). Transportation and associated costs are interesting. We get direct feedback on gasoline prices but those are quite volatile. When one retires and does not incur daily transportation costs to get to work that has a direct impact as well (I welcomed the $6/day savings of not having to ride the DC Metro to my office each day!!).

I don't know if it would be easy to work in some kind of age adjustment into the CPI as there are direct impacts. Of course if the CPI is inflated, then the USG has been paying out way too much in Social Security payments!!!!

Jon Murphy writes:

@Conscience of a Citizen

K&L leave open, but carefully omit to mention, the possibility that those disappearing products also "may have been replaced" by more costly or worse products. As, for example, motor gasoline was (mostly) replaced by gasohol.

Absent some kind of mandate, the likelihood of products being replaced by more costly/worse products is very small; I'd put it at near 0%, especially over the long term. In any given time period, higher cost products could chase out lower cost ones (not sure how, absent a mandate, but I'll grant that Fortune can be a strange creature), but over the long run, such an outcome is highly improbable and unlikely to have any effect on CPI. The reasoning is simple: competition. I think even tariffs, which can have a short-run effect like what you're suggesting are unlikely to have a long run effect.

But, I did say "absent a mandate," so the question becomes: how pervasive are these mandates? There are a few out there: ethanol, Obamacare, etc, but they're not highly pervasive.

In short, I do not think the effects you're describing are strong, at least not strong enough to counter the effects Prof. Henderson or K&L are discussing. When you factor in how much better people live despite supposed flat real incomes, I think it becomes extremely hard to pitch the "inflation is understated" argument, or that good products are being chased out by bad.

Floccina writes:

@Conscience of a Citizen

Gasoline is not we really what we are trying to buy but travel at a given level of comfort and prestige. ICE's have been getting more efficient at about 1% per year. That adds up.

robc writes:

Wouldn't it be a lot easier to go back to the old definition of inflation as change in the money supply?

Calculating inflation as change in M2 or something like that seems a lot easier than calculating the CPI and all of its problems.

Of course, by M2, inflation is much higher than currently calculated.

Inflation

David R Henderson writes:

@robc,
Wouldn't it be a lot easier to go back to the old definition of inflation as change in the money supply?
Yes. But then we wouldn’t get the answer to the question that many of us care about: what has happened to the cost of living.

Conscience of a Citizen writes:

@Floccina

"ICE's [gasoline engines for automobiles] have been getting more efficient at about 1% per year. That adds up."

It doesn't add up very fast! By the Rule of 70, a compounding 1% per year improvement (holding everything else constant) will double gas mileage in 70 years.

If "inflation" (which Scott Sumner sorta-kinda-not-exactly calls "NGDP growth" and wants to see higher) runs merely 2% per year, then the price of gasoline (again, holding everything else constant) will double in 35 years.

So better cars probably won't save us from rising gas prices-- by the time car engine efficiency doubles, fuel will cost four times as much.

Improved productivity in the petroleum fuels sector (fracking, anyone?) could hold the price of gasoline down. The opposite could make it go up extra fast. Perhaps substitution of other fuels will first drive the price of gas down (competition) then, when it doesn't matter so much, drive it back up (higher prices to exploit the low price elasticity of demand from holdout gasoline users). But if the general price level keeps going up at 2% or more, a steady 1% improvement in engine efficiency will not keep up. (It hasn't nearly kept up over the last several decades.)

Conscience of a Citizen writes:

@Jon Murphy

I think "mandates" are pervasive, getting worse, and contribute a lot to rising prices ("inflation").

Occupational licensing, all kinds of "regulation," land-use restrictions, taxes ostensibly collected to fund public services diverted into bloated pensions for government-union retirees (so the "quality-adjusted price" of stuff like driving around keeps going up-- more congestion, more tire damage, more broken windshields, higher insurance premia, etc.). . .

At the same time, crony-capitalist oligopolies raise prices and restrict supply in almost every sector of the American economy. Big oligopolists pay politicians to increase regulations to exclude new entrants. A few oligopolists behind a slew of faux-competitive "brands" representing long-since-acquired-and-merged past competitors routinely replace "low quality-adjusted price" products with "higher quality-adjusted price" products and since there is very little competition, such buyer-adverse substitutions are not deterred by competitors. K&L do not write about reality, they write about a fantasy of microeconomic perfect competition which does not actually exist today.

Because of rent-seeking, for many purposes it is not even possible to distinguish between oligopoly abuses and government mandates-- there's a cycle in which big firms seek government mandates whch help those firms increase their dominance so they can seek even more mandates, round-and-round. New firms only take root in novel business sectors (Internet, anyone?) or overseas.

Jon Murphy writes:

@Conscience of a Citizen

The problem is most kinds of regulations (absent mandates), land-use restrictions, taxes, etc do not have the effect you describe, namely replacing good products with bad. They slow down the process of competition, yes, but absent a mandate they do not cause lower priced products to disappear in favor of higher cost products. In other words, inflation likely is not as low as it could be, but that does not mean inflation is rising.

robc writes:
But then we wouldn’t get the answer to the question that many of us care about: what has happened to the cost of living.

Seems like a question totally unrelated to inflation.

And, IMO, not something that can be done at a level larger than the household.

IVV writes:

"But then we wouldn’t get the answer to the question that many of us care about: what has happened to the cost of living."

So, what has happened to the cost of living? And why is food, housing, and medical care outpacing inflation and wage growth so greatly and becoming so much more expensive in America, especially compared to other developed nations?

LK Beland writes:

Didn't the BLS adjust some of its methods after the Boskin Commission? I thought that inflation over-estimation is now about half its pre-Boskin level.

Per Robert J. Gordon:

"Including those improvements that the BLS has announced for implementation in 2000-2002, the paper estimates that the current upward bias in the CPI is in the range of 0.65 percent, down from the 1.1 percent that the Report estimated applied to the period 1995-96."

http://www.nber.org/papers/w7759

David R Henderson writes:

@IVV,
So, what has happened to the cost of living?
To answer that, go find the CPI over time and subtract at least one percentage point from it annually.
And why is food, housing, and medical care outpacing inflation and wage growth so greatly and becoming so much more expensive in America, especially compared to other developed nations?
Before I take time to answer, please give me some cites to back your claim. I’m pretty sure it’s not true for food. It may be true for housing and medical care. If so, I have thoughts on that. But, again, give me some credible cites so that I know there are facts there to explain.

IVV writes:

Here's a few statistics regarding food prices:

Milk: https://www.statista.com/statistics/236854/retail-price-of-milk-in-the-united-states/

Potatoes: http://www.in2013dollars.com/Potatoes/price-inflation/1997

Chicken: http://www.in2013dollars.com/Chicken/price-inflation/1997

Wheat: https://tradingeconomics.com/commodity/wheat

Certainly the commodity bubble in 2008 is an exacerbating factor, but I guarantee that grocery shopping has become a costlier endeavor. (Incidentally, I had to forecast cocoa prices for a large food & beverage company in 2008. That was a doozy.)

Quick and dirty cost of living comparator between USA and Germany: https://www.numbeo.com/cost-of-living/compare_countries_result.jsp?country1=United+States&country2=Germany

(This in particular has been something I've watched for a while now. You can't earn in Germany like you can in America, but your money goes considerably farther.)

David R Henderson writes:

@IVV,
Prices on milk, potatoes, chicken, and wheat don’t tell much about food prices in general and how they have risen or fallen.
Your cost of living comparison between the U.S. and Germany is just that: it doesn’t address your claim that "food, housing, and medical care [outpace] inflation and wage growth so greatly and [are] becoming so much more expensive in America, especially compared to other developed nations.”
The issue was rates of growth of prices, not levels of prices.

Jon Murphy writes:

@IVV and @David Henderson

I think it's also worth noting that the share of the budget and the number of labor-hours needed to afford food items have fallen in the US. I know Don Boudreaux and Mark Perry have done work on this very topic Here is Don and Here is Mark.

Just some food for thought (forgive the pun)

David R Henderson writes:

@Jon Murphy,
Thanks. That’s why I was doubtful about his claim about food.

Conscience of a Citizen writes:

@Jon Murphy

Not me, but K&L, talked about "quality-adjusted price" which obviously means that if quality stays the same and nominal price goes up, that's just as bad for the buyer as the nominal price staying the same and the quality going down (as happens with shrinking candy bars).

What I think you're calling mandates are everywhere. CAFE regulations make automobiles crappier. So-called "energy-efficient" appliances cost consumers more than they will ever save in electricity. "Renewables" mandates make electricity more costly and less reliable, which bleeds into all kinds of products. Urban growth boundaries and prescriptive zoning make housing both crappier and more costly.

Most people spend most of their money on housing, transportation, food, clothes and sundries, services (medical, cosmetic, home and auto repairs, plus education for the young), some appliances, and entertainment-- which nowadays does involve a lot of gadgets. The gadgets seem to be competitive, but all the other stuff is mandate city: it is express government policy to force up the price of housing, to drive up the quality-adjusted price of cars (transportation) and appliances, and as for medical and (to an astonishing degree) educational services, deliberate government policy drives up their prices. It is even government policy to push up the price of haircuts, by requiring 2,000 hours of training to get a license to cut hair.

Jon Murphy writes:

@Conscience of a Citizen

which obviously means that if quality stays the same and nominal price goes up, that's just as bad for the buyer as the nominal price staying the same and the quality going down (as happens with shrinking candy bars).

I disagree. It's not nominal price that matters; it's real price. If the nominal price of, say, beef goes up 10%, the quality stays the same, but my nominal income goes up 20%, then the real price of beef has fallen. I'm getting the same quality for a lower price.

David R Henderson writes:

@Jon Murphy,
If the nominal price of, say, beef goes up 10%, the quality stays the same, but my nominal income goes up 20%, then the real price of beef has fallen.
Not true. It takes a lower percent of your income, but the way we would tell what happens to the real price is to compare the increase in the price of beef to the increase in the CPI, taking account of the fact that the CPI overstates inflation by over one percentage point.

Jon Murphy writes:

@Prof Henderson,

You are right. Forgive my sloppy thinking here. I was thinking "relative price," but wrote "real price" instead!

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