Inflation is a top concern of voters. Yet economists generally argue that the costs of inflation are exaggerated. Can we reconcile these views?
To begin, inflation as measured by the Consumer Price Index (CPI) has fallen significantly since hitting 9.1 percent in June 2022. Inflation was 7 percent for all of 2022 but only 2.9 percent in July.
Remember also that inflation is the rate of change in prices. A decline in inflation means that prices are increasing slower. To return prices to 2021 levels would require negative inflation, or deflation.
Economists normally think about a “pure” inflation, or equal percentage increases in all prices, including wages and salaries. Five percent inflation then is a five percent increase in the prices of all goods, services, and labor. The increase in wages should offset the higher prices (ignoring tax impacts).
An increase in the prices of only some goods is a change in relative prices. A ten percent price increase for food, energy, and transportation might increase the CPI by five percent. This is not, strictly speaking, inflation and since wages do not rise, people will be worse off.
I think economists should focus on how inflation impacts families. Understanding decisions as viewed by the subjects of our analysis is a core element of economic research.
The CPI measures the cost of purchasing an average market basket of goods which no household probably buys. The effective inflation rate for households depends on the things they buy. Today some face more than 2.9 percent inflation.
Raises do not come automatically with price increases except with a COLA or Cost of Living Adjustment. COLAs adjust wages or salaries as the CPI rises. Social Security benefits get COLA adjustments, but only about one in ten private sector employees have COLAs.
Consequently, most workers are not guaranteed an offsetting raise. Inflation therefore generates uncertainty, which is stressful. Also, many Americans’ “raises” came from changing jobs, which entails its own costs and stresses.
An offsetting raise, if received, comes after prices rise. Monthly budgets were still stressed during 2022 even for those receiving a seven percent raise at year’s end. Wages generally lag prices in the inflation race.
Many Americans do not save annually and have little accumulated savings. Higher prices for essential items create hard decisions. Most economists can afford an extra $100 a month for groceries without a raise. We fail to recognize the burden higher prices impose on many families.
A change in calculating the CPI may heighten the divergence between measured and felt inflation. Substitution bias contributed to the CPI overstating the inflation rate. The CPI market basket does not change monthly as prices rise and fall, but consumers will respond.
To illustrate, suppose Coke and Pepsi initially sell for $4 a bottle. The price of Pepsi rises to $6 while Coke stays at $4, a 25 percent increase in the average soda price. The impact on consumers is less than the 25 percent increase resulting from both prices rising to $5. Many will substitute Coke for Pepsi here.
Beginning in 1999 the Bureau of Labor Statistics began adjusting the CPI for substitution bias, which makes sense. But consumers miss out on some satisfaction even if substitution keeps budgets from busting.
A final consideration involves the COVID and lockdown supply chain disruptions. Shortages create significant economic pain, in several ways.
To see how, during the baby formula shortage, desperate parents drove from store to store. The time and gas spent searching increase the effective price of formula when finally purchased. Items not consumed reduce consumer satisfaction. And shortages produce uncertainty.
The prices necessary to keep some items in stock provide a way to value the impact of shortages. Measured inflation if prices had risen like this would have significantly exceeded seven percent.
To be precise, this pain is due to the shortages and not inflation. But people likely associate it with recent inflation.
A simultaneous equal percentage increase in all prices and wages might not be very painful. But that’s not how inflation works. Recognizing the felt pain illuminates Americans’ concern with inflation.
Daniel Sutter is the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University and host of Econversations on TrojanVision. The opinions expressed in this column are the author’s and do not necessarily reflect the views of Troy University.
