“We just paid our home insurance, and it rose by 44.5 percent. How can the officially published inflation rate be low when one sees instances of immense price increases?” That query, in an e-mail from a reader, raises some useful points. How can inflation remain low when there are double-digit increases in the prices of important goods or services? And how can prices of a service such as insurance increase by so much at one crack?
To understand variables in prices, it helps to understand how price indexes work. A price index is a yardstick for measuring changes in general price levels. The best known such yardstick is the Consumer Price Index, which measures changes of prices of goods and services bought by households.
When tabulating the Consumer Price Index, the Bureau of Labor Statistics records the prices of a large number of goods and services that broadly represent how typical households spend their money. It repeats this process every month. The percentage change in the prices of these goods and services from month to month yields the percentage change in the overall index.
But not all goods and services have the same importance or “weight” in household expenses. Most of us spend much more on gasoline than toothpicks or more on hamburger and chicken than on salt or shoe polish. A 10 percent increase or decrease in the price of gas or meat affects us much more than an identical percentage change in minor sundries.
Therefore, one explanation of why measured inflation may remain low even when specific goods or services undergo whopping price increases is that the “weight” or importance of these items in average household spending is low.
Another factor is that some goods decline in price. Human nature is such that we tend to pay more attention to price increases than price decreases. When we get an insurance bill that is hundreds of dollars higher than the year before, we sit up and take notice.
But we seldom pay much attention to prices that decline slowly over time. Many electronic devices and appliances are in this category. In 1961, a family friend bought the first color TV in our neighborhood. It cost him more than $650 in 1961 dollars, which would equal about $3,900 adjusted for inflation to mid-2002. We can go to any appliance store and get a new color TV of the same screen size as Harry’s for a tenth of that amount and it will be vastly more reliable than his 1961 model.
Another example is the microwave oven. Last Sunday I opened the Sears sale flier and noted that Kenmore brand microwaves were available for $59.99. My wife commented that when she got her first Sears charge card in 1982, the first thing she bought was a microwave. It cost her $350 for a somewhat larger model than the one on sale for under $60.
Again, adjusting for inflation, a $350 purchase in 1982 would equal $630 in 2002 dollars. But microwaves are much cheaper than 20 years ago as are VCRs, some power tools, air conditioners, and clothes dryers.
The lesson here is that not all prices of all goods and services change at the same rate and in the same direction. Many go up while some go down. Not all goods are of equal importance. Tabulating a price index has to take all these factors into account if a useful, albeit imperfect, economic yardstick is the desired result.
© 2002 Edward Lotterman
Chanarambie Consulting, Inc.