What You Need to Know About Inflation

What You Need to Know About Inflation

June 21, 2021 MST  Category: General Investing 

The rate of inflation went up this Spring and that has caused some significant fluctuations in the market as well as a lot of talk about inflation. Given the fact that inflation has been low for so long, novice and young investors may not know a lot about inflation, so today we're going to take an in-depth look at it.

 What Is Inflation?

Inflation is a general increase in prices and thus a fall in the purchasing value of money. In essence, your money is worth less than it used to be. It buys a smaller quantity of goods and services.

 How to Calculate Inflation

The most common measurement of inflation in the United States is the government's measurement, known as the Consumer Price Index (CPI). There are actually multiple CPIs. The most common is the CPI-U, the consumer price index for all urban consumers. However, there is also a CPI-W, the consumer price index for urban wage earners and clerical workers, and a CPI-E, the consumer price index for the elderly.

You may also hear about “chained CPI” or C-CPI-U. As a general rule, C-CPI-U is lower than CPI-U is lower than CPI-E and CPI-W varies. The government also measures inflation using the Personal Consumption Expenditures Price Index (PCEPI). The Federal Reserve uses this and considers it a bit more accurate than CPI. It generally runs lower than CPI-U by about 0.5% a year over the last 50 or 60 years.

For the most part, when people talk about the rate of inflation they are talking about the CPI-U. However, the inflation measurement used for Social Security inflation adjustments and federal pension inflation adjustments is actually CPI-W. CPI-U is used in many private collective bargaining agreements, however. The price of school lunches is also indexed against CPI-U. CPI-U is the one used to determine the rate paid by TIPS and I Bonds.

Core CPI (officially called “Consumer Price Index for All Urban Consumers: All Items Less Food & Energy”) is used by many economists and thought to be more useful than CPI-U. It is basically CPI minus some relatively volatile items such as food and fuel. It is much less volatile than CPI, although less broad.

“Chained” or “chain-weighted” simply takes into account product substitutions as discussed below.

Criticisms of CPI-U

There are many criticisms of the CPI process. Some are quite valid and reasonable while others are promoted by conspiracy theorists and can be nonsensical. Academics have criticized CPI-U for having an upward bias. Their argument is that CPI overstates inflation because:

It omits consumer substitution

It doesn't account fully for quality change and

It doesn't reflect the addition of new goods.

Consumer substitution is the effect that when the price of one thing goes up, people buy something else. So if the price of beef goes up, people buy less beef and more chicken. Quality change refers to the fact that when you buy a computer or a car these days, it is a far better product than what you could have bought 10 or 20 years ago. Essentially the thought is that it SHOULD cost more because it is better. It's not the same thing.

The same argument might be applied to housing, education, and health care as well. The “addition of new goods” argument is that when a new product or service is introduced to the market, it makes a dollar more valuable, since it can buy more. But that new item isn't in the CPI and so the CPI doesn't affect that additional value.

The financial community, particularly people with inflation-indexed salaries, pensions, or other financial benefits, often criticizes CPI-U for having a downward bias. This view is quite prevalent in the general public. There are a number of reasons for this view. Part of it is distrust of the government.

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