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Inflation Numbers Are Distorted And Higher Than Actually Reported

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EDITOR NOTE: Is the government’s inflation measures presenting a picture that’s much rosier than reality? The article below argues that it does--that all standard indicators are not nuanced enough to account for what households are really experiencing, and that real inflation begins in these small corners of monetary ignorance, often glossed over by the cumulative headline figures. The cost of everyday necessities have risen significantly, and our economy hasn’t even reached the Fed’s 2% inflation target. Imagine what the cost of living will be like when the Fed finally overshoots it, as it aims to do.

The latest inflation statistics say prices have risen by only 1 percent over the past year. But there’s something wrong with those numbers because the pandemic has made economic life more expensive in ways the official bean counters aren’t capturing.

This distortion has led other economic statistics to paint an artificially rosy picture of our current situation. The problem is that measures like real output, real wages and poverty are calculated using inflation adjustments that don’t reflect the higher cost of living during a pandemic. This might help explain why measured poverty has fallen even as lines at food banks have grown.

The government’s approach to measuring inflation is straightforward enough. The Bureau of Labor Statistics tracks the price of a basket of goods and services that is intended to represent average American patterns. The inflation rate is the monthly percentage change in that price.

But no economic statistic can perfectly track the cost of living. In normal times, the government’s numbers are thought to overstate the true rate of inflation. But the pandemic has upended the economy in ways that have reversed these biases, so that the official statistics are now an underestimate.

People are buying more of those goods whose prices are rising the fastest.

The Consumer Price Index tracks the cost of a fixed basket of goods, but people constantly change what they buy. This “substitution bias” usually leads inflation statistics to overstate changes in the cost of living, because people tend to substitute lower-cost alternatives when prices rise.

But since the coronavirus hit, people are buying more of the essentials, like groceries, forcing their prices up. And they’re buying fewer airline tickets and less gasoline and clothing, pushing those prices down.

Alberto Cavallo, an economist at Harvard Business School, has mined credit and debit card data and found that these changing buying patterns are especially important for low-income households, which devote a larger share of their spending to food.

While poorer people often try to keep the cost of living down by buying whichever brand happens to be discounted that week, the pandemic appears to have reduced the number of discounts.

The pandemic has changed where and how people shop.

The price that Costco charges for Cheerios has not changed much, but during the pandemic my family is visiting Costco less and relying on Instacart instead, which charges a premium for delivery.

The Cheerios are identical — Instacart even picks them up from Costco! — but Instacart charges a premium over Costco’s low prices. While my weekly box of Cheerios has become more expensive, the government statistics infer that if neither the price of Cheerios at Costco nor the price of Cheerios from Instacart has changed, there must be no Cheerios-related inflation. My wallet disagrees.

In general, the risks associated with in-person shopping have led many people to shop around less, or to switch to more expensive online or delivery options, and they’re often also adding a healthy tip. As a result, the cost of living for many families has risen in ways that the Consumer Price Index fails to capture. (By contrast, in normal times people tend to flock to cheaper outlets, so this “outlet bias” usually leads official statistics to understate inflation.)

The quality of many services has gotten worse.

Typically, many businesses add new features, or improve the quality of their products. Government statisticians try to make adjustments for how the changing quality of goods affects the price. It’s hard to account for every change, so these unmeasured quality improvements often lead the statistical authorities to overstate how fast the cost of living is rising.

But the pandemic has forced many businesses to switch to producing lower-quality products. That restaurant meal you might have enjoyed with table service and mood lighting is now offered in a foam container to eat at your kitchen counter. Your therapist might be available over Zoom, but is it really an adequate substitute? And few colleges are offering discounts this year, even as they’re moving to largely online instruction, which my students tell me is a vastly inferior product.

Even as the price tags on these products haven’t changed much, their quality has declined, which is a hidden form of price increase ignored by the official inflation numbers.

Variety has decreased.

We’re living in a time of shortages. Bikes, dumbbells, bread makers (or even just yeast), camping equipment or Nintendos are hard to find at any price.

While you might view this as an effective price hike (to infinity and beyond!), the government statisticians don’t see it this way. They impute the price of what a sold-out good would have been if available, effectively ignoring the inflationary costs of pandemic-fueled shortages. The problem is that fewer choices give you fewer options for achieving a given quality of life.

In normal times, businesses continually introduce new varieties that the inflation numbers fail to capture, creating a “variety bias,” which overstates the true rise in the cost of living. But the pandemic has led to a sharp reduction in the number of goods and services available — including child care — which effectively amounts to a hidden increase in the cost of living.

The true inflation rate has risen.

Put these biases together and it appears that the cost of living has risen substantially faster than the official inflation numbers. These numbers directly affect people’s lives, because Social Security benefits and other programs are tied to inflation numbers that aren’t keeping pace with the higher cost of living.

Peter Klenow, a Stanford economist, told me by email that much of this distortion was “likely to be transitory.” Once the pandemic recedes, he said, “most of the lost varieties will eventually be regained,” and “spending patterns will largely revert” to their earlier patterns.

But this temporary shift matters because it changes the diagnosis of our current economic ills. If inflation were falling — as the official statistics suggest — that would be read as evidence of insufficient demand, as people cut back on their spending. But if inflation is really rising, that suggests that supply side disruptions are a bigger problem than is widely appreciated. The source of these supply disruptions is in plain sight: It’s the virus.

This diagnosis says that fiscal and monetary policies to bolster demand will be most effective when paired with effective public health measures that make it safe for suppliers to get back to business. The payoff to beating the bug isn’t just that it’ll save lives. It may also save the economy.

Originally posted on DNYUZ

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