Hiding Inflation in the Price Index

In an effort to measure more accurately the rate of inflation at the consumer level, the government recently overhauled its widely followed consumer price index. Geared to spending patterns from 1982 through 1984, the new CPI may be a better measure of people’s tastes, but it is likely to be no better than the old one in gauging people’s perceptions toward inflation.

If one were to believe the CPI, inflation has just about disappeared. Over the past two years, the consumer price index has risen a total of 5.3%. In 1986’s second quarter, prices fell at an annual rate of 1.7%--the first quarter-to-quarter decline in 25 years and the biggest such drop since 1949.

To make matters even more satisfying, personal income growth has remained substantial. Between 1984 and 1986, individuals’ incomes rose 12%; they increased even faster if you do not include the farm sector.

You would think that people would be cheered by this news. Yet many have a gnawing suspicion that there’s more inflation out there than is captured by the CPI.

In an era of seemingly moderate inflation, price increases still pop up, and each is a nuisance. It seems as if one is constantly paying more for one small item or another. As a consequence, most people would question whether their spending has risen only 5.3% in the past two years.

They have every right to be suspicious. For the new CPI--like its predecessor--does not measure either total spending or the cost of living. Rather, it merely prices a market basket of goods and services, weighted in importance according to people’s annual spending patterns.

The percentage changes announced each month are for the same market basket. They don’t take into account variations in consumption patterns that might arise from changes in relative prices.

For instance, if meat prices rise and fish prices fall, many people would buy less meat and more fish. Yet, because the consumption weights in the CPI are fixed, this shift in buying habits does not influence the index.

Needless to say, the CPI does not pick up what happens to people’s buying habits as their incomes change. A substantial jump in someone’s income would probably reduce the proportion spent on certain items like food. The converse would be true in the event a person’s income declines.

Finally, the market basket concept forces the CPI to assume that everyone buys the same goods each month. This may be true when it comes to small-ticket items like food, clothing, fuel and many services. It is not so in the case of such big-ticket items as cars, houses and home furnishings.

Although most people buy these big-ticket items infrequently, their large price tags earn them a big weight in the CPI. However, common sense would argue that it is prices of frequently bought items that tend to shape people’s attitudes towards inflation.

With this in mind, my colleagues and I at Manufacturers Hanover have assembled what we call a “nuisance index” consisting of three dozen goods and services commonly purchased during a month’s time. These include foods such as coffee, orange juice, roast beef, ice cream and pizza; other goods such as detergents, toothpaste, paperback books and news magazines, and services such as a cab ride, a woman’s haircut, a movie and the dry cleaning of a suit.

Because they are small-ticket in nature, they account for less than 20% of people’s total yearly spending and are treated accordingly in the CPI. Yet these are the items that people buy most often--and in the past two years, their prices have jumped nearly 30%.

There are several implications to be drawn from this. First, of course, is the fact that once again the government does not appear to be telling the whole truth to the American public about the state of the economy. Second, bond traders--who are consumers as well--may have used the rising prices of small-ticket items as a reason for keeping interest rates high even though the CPI has grown quite slowly.

Why are retailers raising their prices so quickly? One must note that they are labor-intensive businesses, with few prospects for improving their productivity, so they must raise prices to offset even the smallest increases in their labor costs. Also, many retailers are faced with rapidly rising rents, utility bills and local taxes.

Finally, the public tends to accept higher prices for small-ticket items because, while the increases are large in percentage terms, they are small in actual dollars and cents. In fact, these constant nickel-and-dime price increases are the real nuisance in our nuisance index, not the goods themselves.