What Is the Real Inflation Rate?

I recently received the following question:

Please explain to me how my cost of living can increase by 10-15 percent, grocery bills, fuel, energy, clothing, etc. yet my income only increases about 2-3% which typically matches inflation.  I have talked to many people about this and a lot of folks feel the same way, how can inflation only be 2-3% when the cost of living keeps going up 4-5 times that number. I am a college student, but only in my first few years so please explain this in basic terms so that I may understand.

Thank you tremendously,

Jessica

This is a common question– often it is phrased as “What is the real inflation rate? Who do I believe?”

There are several explanations:
The cynical one is that the Government is a shady character and fudges the numbers. There are many commentators who play to this distrust of government and the fact that it is often in the Government’s best interest to have the inflation rate as low as possible. (It reduces their escalation cost for things like Social Security benefits that are indexed to inflation).
The government’s alternative explanation is that everyone’s expenditures are different and they track 80,000 different items and take the average based on percentage usage.  For instance they may estimate that the average family spends 5% of their income on gasoline so they calculate the CPI based on 5% gasoline and 1% bread and 10% rent, and whatever.  (I just made up numbers not actual government percentages). However, if you drive a lot more than average you might spend 10% of your income on gas and so your averages would be different. Also education has increased much more than most items so as a student you would be more affected by that.  (see our article on education inflation).

Inflation is all in your head?

Psychologists might say that your perception is the problem,  you only focus on the items that are going up and are ignoring all the balancing items like, computers, and electronics, etc that are going down. This is human nature and actually a survival mechanism.

Imagine you are walking along and you get a small pebble in your shoe…  before long that is the major focus, you can think of nothing else.  This “irritant” becomes much larger in your perception than it really is. When it was among all the other pebbles on the path we didn’t even notice it.

This is good… when it comes to most things because it allows us to get rid of the pebble before it causes a blister on our foot.  In regard to inflation however it may skew our perception as we focus on the irritants and ignore the “blessings”.  It might also relate to whether you are a “glass half full” or a “glass half empty” sort of person.

Another problem is that recently the price of highly visible things like gasoline have gone up significantly in a short period of time so we say to ourselves, “see how much prices are going up… gas went up 20 cents in the last month alone”.  However we forget that it went down 20 cents over a three month period six months ago.  This means that gasoline prices might actually be at the same level as a year ago.  But our short term focus only lets us see the recent increase.  As of this writing that is exactly the case… gasoline was over $3.00 a gallon a year ago, then it gradually fell back to almost $2.50 then rapidly jumped back to around $3.00.

On an annual inflation basis, gasoline inflation would be zero but on a monthly basis it might be 10%.  Mentally however we say “see gas is up 10% in a month, how can inflation be only 3%?”  But when gasoline prices are falling we tell ourselves ahhhhhhh prices are returning to where they “should be”.

What’s the real explanation of inflation?

Perhaps, a little of each. I certainly won’t say the government isn’t fudging the numbers, but I do know that our perception is one factor and our personal usage patterns do have an effect on our personal inflation rate.

 

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Comments

  1. Henry Drake says

    While people may want to tell you that it is “opinion” that the government fudges its numbers horribly, or that it’s just rhetoric by “commentators” with an agenda – consider this: The Government has changed the formula for calculating the CPI a number of times since the high inflation of the 70s – this is neither a secret nor an opinion, but fully a matter of public record, and in every case the change was such that the calculated rate was lower (of course). When we say the government “fudges” the numbers, we’re not saying they are lying about the raw data (as far as we know), but that they are changing the formula to get the results they want. The fact is, if you compare apples to apples, rather than apples to watermelons, and use the original 1970s CPI formulas, you will find that inflation has been running at 10%-ish (more or less) for years. We have been in 1970s-era “stagflation”, using the government’s formulas that were in use at that time, for at least a good 4 years now. Sure, it’s true that people will usually overpercieve their own cost increases, but it’s a matter of overpercieving a 10% rate as 15%, not overpercieving a 2% rate as 15% – we’re not that bad at judging cost increases over time.

  2. J. Dowd says

    I hear this argument from the right, and the left; don’t worry, there is almost no inflation. Yet when I compare my home heating bills from last year, the year before that, etc. to this year, in two years I’ve gone from 3.39 a gallon to 4.09, and groceries? Get real! Way up, cost of materials for home repairs, up, clothing is so far down in quality/ thread count, that you have to replace a pair of pants in half the time you used to. Ask anyone how long a pair of Levis lasts now compared to years past. Then look at the same size bag of whatever, and notice the weight is lower, count is lower, though price is up. My wages are stagnant, have not gone up in ten years. Others say the same, wages stagnant. These are facts, and to suggest otherwise is propaganda…period!

  3. Tim says

    It is staggering. Wade is right. Since when do I buy a computer every month – if ever. I don’t NEED one. And, I cannot eat a computer either or use it to get to and from work. It is BS.. I believe it is due to social security benefit and pension increases being tied to CPI. Check out Khan Academy explanation.

    Tim

    • says

      You are right the CPI allocates 15.256% of its importance to food and beverages, and 41.02% to Housing, 3.56% to apparel, 16.875% to transportation, 7.06% to medical care, 6.04% to recreation, 6.79% to education and communication. And only 0.26% to computers, 0.05% software and accessories, 0.58% for internet service totaling 1.006% for all Information technology hardware and services but the improvement in technology also affects Telephone services 2.42%, and a portion of the above mentioned items like health care, education and communication. To see the entire breakdown go to http://www.bls.gov/cpi/cpiri2011.pdf

  4. Wade says

    Say what you will. All or almost all of the staples for me have gone up. Electronics? Poooh! That’s such a small part of the budget. I’m not a betting man, but if I was given the opportunity, I’d bet a lot that if real, reliable stats could be had, we’d find that real inflation (costs for the average man’s main budget items like energy, rent, food, clothing, basic utilities, transportation, etc) is staggering over the past four years.

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