Setting Inflation Straight, Part III (at least)

You ever noticed how inflation seems a lot worse than the official numbers indicate?

Via Yahoo, Fox Business reports on the change in prices for a sample of everyday grocery items. It shows quite a shocking increase over the past year, far more than you might suspect from the "tame" inflation numbers you hear about.

I've reproduced the prices from that article in the table below, showing the current, March 2010, and March 2006 values. (I couldn't find the numbers in the source cited, but will operate on the assumption they all refer to March of that year, even though it suggests they average over 12 months in the previous year; this would mean the results I calculate actually understate inflation.)


Yikes! The average 1-year price increase for this sample is over 8%!

So what is the offical food price increase? The BLS CPI report on page 2 gives their aggregate 1-year food price incease as only 2.9%!!! And if you think 1 year is too short because of volatility, then look at the five-year food inflation numbers, a time period that covers the "massive" price collapse and "deflation" following the 2008 crisis onset: 4.7% per year.

And this is still:

- ignoring all quality debasements, and
- in an environment where banks are holding on to their massive reserves, suppressing price increases!

I've listed the corresponding prices for gold (though they're all relative to the present instead of March of any year), using an ETF (ticker symbol GLD) that tracks it. Looks like it works well (if a bit too well) as a barometer of dollar debasement. Hope you stocked up back then! (By a great coincidence, a financial advisor in April 2006 looked at me like I was insane for suggesting putting any money in gold.)

But don't worry, your iPad holding more memory will make up for this, I'm sure...

Almost funny...

... except for the fact that the Fed really does think like this.

Onion Video: Should The Nation's Unemployed Be Buying New Apple Computers?

Setting CPI silliness straight ... again

Sorry for the long lull in posting, and I'm a bit late on this story too, but it's very telling. We have on our hands a new modern day Marie Antoinette (or at least the popular image of her): William Dudley of the New York Fed deigned to talk to a working-class audience in Queens, New York on March 11.

He tried to promote the tired line about inflation being low, a story this crowd, well, didn't find plausible:

"When was the last time, sir, that you went grocery shopping?" one audience member asked.

Then, for his "Let them eat cake" moment, Dudley brilliantly replied to these concerns of higher grocery prices with,

"Today you can buy an iPad 2 that costs the same as an iPad 1 [sic] that is twice as powerful," he said referring to Apple Inc's latest handheld tablet computer hitting stories on Friday.

*facepalm*

No, Mr. Dudley. An equal-price, technologically-better iPad really doesn't cancel out my more expensive food, energy, tuition, rent, and health care costs. It just doesn't.

Now, some folks have tried sheepish defenses of this line: "Sure, that might not be the best way to say it, but he's ultimately right that you have to look at all prices, and not just narrowly focus on stuff you'd actually buy."

But even saying that much would be wrong. Remember, when central bankers want to promote the idea of how dreadful deflation is, they dismiss that pesky trend of computer hardware getting cheaper, a trend most people, for some reason, regard as a good thing -- not with the rabid hatred they're supposed to hold for deflation.

But central bank acolytes will always trivialize this phenomenon, saying that, no, that's not the kind of inflation we're worried about -- we only want to count the kind that's affected by money supply, money velocity, liquidity preference, that kind of thing -- not these technology-driven improvements!

And in a way, it makes sense. But at the same time, it certainly means you don't get to turn right around, abandoning the long history of deeming cheaper computer hardware irrelevant to inflation, and count higher iPad performance as somehow canceling out the inflation you do care about. It doesn't work that way. If technology-driven hardware performance isn't relevant to measuring inflation for purposes of monetary policy, you don't get to selectively invoke it at the specific times when you "need the numbers to be lower".

It's good to see some people calling the Fed on this.

Setting monetary stimulus straight

In light of my recent link to Gennady Stolyarov's post about the gloomy future of the economy (especially for young people), I thought it would be a good idea to put it against the backdrop of mainstream economics and the "experts'" solutions.

A characteristic post is this one by the relatively libertarian Scott Sumner. Like pretty much every day, his idea is for the Federal Reserve to do a "monetary stimulus" by injecting money into the economy to prop up nominal GDP. (Yes, nominal GDP -- you know, the one that doesn't mean anything until you adjust it to real GDP and even then commits you to a easily-abused framework.) This, it would do by various mechanisms, all of which aim to "get banks lending". Stop paying interest on reserves, buy more of banks' (junky) securities, rapidly debase the currency ("quantitative easing") so they have to loan or else hold worthless cash, etc.

In frustration at such a stupid policy, I made this sarcastic comment on that post:

Yes, the economy will definitely collapse if the Fed doesn’t print up more money to make shoddy loans for purchases people don’t want, and it’s a shame that folks at the Fed are stopping Bernanke from such a wise action.

And to my utter surprise, Sumner replied:

Silas. I agree. :-)

Note: the smiley was in recognition of my sarcasm, not to indicate he's changed his mind.

So, Sumner realizes exactly what he's asking for, and still thinks it's a good idea. But since it apparently isn't obvious to everyone what's wrong with such a policy, I thought I'd spell it out clearly for once:

Banks aren't lending (in sufficient numbers). Mainstream economists want to prod them into lending. But why won't they lend in the first place? Because they don't expect the future loan payments to justify the loan. Now, when you grip them so tightly that they have to, for some reason or another, make these loans, have you changed the factors causing banks to believe loans won't be paid? No, you haven't. So, the loans will just throw money after wasteful projects, destroying output and making everyone poorer.

Note: even if you -- quite reasonably -- care about unemployed workers, and you dismiss this concern about wastefulness on the grounds that, "hey, at least it will lift off the joblessness albatross for so many families", that still wouldn't make such policies a good idea. The wastefulness means that reality will eventually rear its head and force these projects to be abandoned. Then, all the new skills workers could have developed while working on sustainable projects that satisfy actual demand, instead don't get developed, and whatever they did do has just retooled them for a useless activity, leaving them even worse off. Doesn't sound too compassionate to me ...

But let's say I'm wrong about that. Let's put aside, for the moment, our skepticism about economists' claims that the same policy that forces banks to lend, also causes these loans to work out and get repaid, making them not such stupid loans to begin with. Even then, you're still causing inefficient activities to happen that cause workers and investors to dig themselves deeper on unsustainable activities.

Looking back, one has to wonder how economists ever came to the consensus that making ultra-underpriced loans to clumsy, inflexible banks could ever possibly be a good idea. My suspicion is that it is a kind of Goodhart phenomenon: at the time these economic models were created, the metrics economists cared about did serve as good proxies for general economic health. But as they were targeted by policy, they lost their value as indicators.

Furthermore, economists failed to continually ground their concept of a "good economy" in what is meant by the term in common parlance. They don't keep checking back to see whether their policies would mean that people get the best combination of work, leisure, and consumption (all broadly defined). No: if an improvement doesn't show up as a cash exchange, it doesn't matter. If people aren't spending enough, then obviously that's hurting the economy and they should spend more.

You would almost think the economy is some god that demands sacrifices, given the way economists talk, rather than a characterization of our collective ability to satisfy wants.

So please, understand my anger when I read about how young people have all of their options cut off by the earlier generation, how they can't save or invest because of how much will be taken to make up for the failures of poorly run enterprises, how genuinely productive ventures are quashed by an outdated mentality of how the world should work ... and then Scott Sumner swings in to tell us that the best way to improve "the economy" is with ridiculously underpriced loans from newly-printed money to aging, inefficient companies that just wasted trillions of dollars destroying our productive capacity.

Advice for economists: Ask whether, not why.

-Don't ask, "What can we do to increase aggregate demand?"
Ask, "Why should we increase aggregate demand?"

-Don't ask, "What can we do to keep people from saving so much?"
Ask, "Why does 'the economy' so crucially depend on people not saving, and why do I care about the health of the 'economy' in that sense?"

-Don't ask, "What can we do to get (traditionally measured) output back up?"
Ask, "Why is it necessary for that measure of output to go up? Would it be so terrible for people to produce less, if that's what they really want, based on honest assessments of the future?"

Get the picture?

Setting the future economy straight

Gennady Stolyarov II does it much better than I can in a guest post on Bob Murphy's blog.

My summary: young people are f'ed. New and existing laws, along with entrenched norms, make it effectively impossible for them to succeed through standard education and career paths. Success has become decoupled from merit, and the upcoming generation will be barred from home-ownership, even if they're responsible. A constellation of irresponsible financial policies by the government shifts most of the cost of government to these young people through ever-growing inflation, taxes, and one-size-fits-all laws. The only answer is for the new generation to break from traditional norms and bypass the standard dinosaur institutions, using new technologies -- mainly the internet -- to meet their economic needs, without the waste and inefficiency that has crept into the system over time.

Lots of thoughts I've had, but put together with rigor I have yet to match on the issue.

Spot the common professional economists' error

From James Hamilton:

When academic economists talk about inflation, we often think in terms of a single-good economy in which the concept refers unambiguously to an increase in the dollar price of that good.

If you can't wait for me to give you the answer, just go to the link and find my link. Well, I don't give it there either.

Anyway, all I can say is, if you make this kind of error at the beginning, don't expect me to put a lot of faith in your analysis...

Inflationary product debasement turns tragic

Previously, I had highlighted the problems in inflation measures that don't take into account when a product is debased in order to hide its true cost. Well, another case of that has come up in the news: the FDA melamine regulations permitting trace amounts of the stuff in baby formula. From the beginning:

This weekend, I saw a news story on TV where a doctor was explaining that, while melamine is most likely safe in these trace amounts, it "has no business being in baby formula" because there's no benefit to the baby, there's a risk of harm, and you just don't need it to make formula.

My immediate reaction was: Okay, if it's so bad, there must be some reason producers would want to include it. After all, businesses don't e.g. pollute just for fun; they do it because that improves product quality and/or cost -- er, at least it appears that way to the most highly-visible parties.

As the story continued, the doctor answered my question by saying that it's included in order to fool the tests used to determine protein content. I don't remember the channel, but I found a San Francisco Gate story substantiating that claim:

Melamine contamination became major news when it was discovered that China was adding it to milk to disguise test results that measure protein levels. Since the chemical was found in infant formula in September, it has sickened some 50,000 Chinese infants and killed 4.

So there's our answer! They use melamine instead of the good stuff in order to pass some protein measurement test. And they only use melamine because it's cheaper, or else what's the point? But, that test has a "blind spot" that will give a "pass" rating to baby formula that only achieved that rating by compromising the "design constraints" of baby formula! So it fits into my template of "compensate for inflation by debasing the product instead of raising the price".

Now, it certainly doesn't take a bout of inflation to make people try to get "something for nothing". But it's a very plausible suspect for why it wasn't tried before.

Of course this is not to take away from the culpability of those who conjure up such unethical policies. And, to some extent, you have to understand the position they're in: when consumers reward those who can keep the visible price low, while ignoring the other costs thereby incurred ... well, don't be surprised when they're all too willing to oblige :-/

So I was right again. Now, let's fix inflation measures.

There's a story on CNN Money today about shrinking and degrading products in response to inflation. Unfortunately, it doesn't give more than passing mention to the real stickler in inflation, the "degrading" part, which is harder for measurers to notice.

Consumers are discovering more air in their bag of chips, fewer sheets of paper towels on the roll, thinner garbage bags and even smaller squares of toilet paper. (emphasis mine)

You don't say! I've been noticing this for a while, and haven't been convinced the BEA and BLS capture the impact. When you pay the same for a debased product, that is price inflation, and precisely what you need to measure. But like the fool who won't search for his keys outside of the light, the BEA and BLS don't do the lab testing necessary to incorporate critical quality-related aspects of products.

In my personal experience, I have noticed cereal boxes and paper cups as being flimsier and thus harder to hold -- about as big an inconvenience as you can tag onto such a simple, trivial product. Soda bottles also had confoundingly irritating changes: in addition to the 25% vending machine price increase, they shrunk the cap height beyond all reason so that it's nearly impossible to get a good enough grip to twist open with your hands. The fact that Coca-Cola even made this decision is a testimony to either a) the low quality of their engineering teams, or b) how desperately they needed to debase the product. Neither is encouraging. (To their credit, the caps have returned to "good enough", meaning they've hidden the price increase somewhere else.)

I should feel fortunate to live in a country where "difficulty in opening products" ranks highly enough to complain about. But that's also worrying: in a country with such enormous, overflowing wealth (which the US has, right?) shouldn't producers have kept such noticeable inconveniences out as a matter of course? Something's not right about that picture...

So, if you really want to measure inflation, you're going to have to track these very tricky quality changes. But there's an alternative: focus on measures were this quality debasement just isn't possible. As I'm sure I've argued here and on several boards by now, the ideal candidate is an insulin index which does the work of policing quality improvements for you. If you debase insulin, someone dies. The other benefits are:

-Steady, predictable demand
-Global market with many buyers
-Many inputs, so it's immune to any one specific input's volatility
-No transient intellectual property effects

Which probably accounts for why such information is so durn hard to find!

Second, in addition to capturing quality degradations, they need to fundamentally rework how luxury-type items are accounted for. Those typically "scale" with what other people have. Faster computers mean enabling nicer software, but they can also mean having to pay for hardware I don't need, as the older stuff isn't available, and my current one can't run the latest software that assumes I have a faster machine. And the value I can squeeze out of it doesn't increase one-to-one with the MegaHertz rating!

I absolutely accept that modern technologies have vastly expanded the entertainment and learning options available to me, but an inflation measure must at the same time account for when food and energy prices put the squeeze on me.

I'd be interested in transforming these ideas into an academic paper, except there are a few things ahead on that list...

Non-existent positive real interest rate spotted!

Dismissing the harm of inflation again, Bryan Caplan confidently announces that it's already priced into interest rates, so it doesn't eat away your savings!

Since most inflation is anticipated, I don't see that it does transfer much; instead, it's built into raises and interest rates.

Oh really now? I'm interested in learning where I can store my money at low risk such that its real after-tax return is positive. Two-year treasuries are yielding 2.45%, much lower than you'd need to beat inflation and taxes. Vanguard's Prime Money Market Fund is yielding 2.19%. (I was going to quote the after-tax return they give, but they seem to have either removed that section, or they never post it for money market funds. My rough calculations show that even if you left your money alone for the last ten years, the nominal ROR at a tax rate of 25% would be ~2.5%.)

Hey, I'm a big saver, but the market -- well, whatever's left of it -- is telling me not to.

Setting the CPI straight

This is an expanded version of a semi-relevant post I made on Menzie Chinn's Econbrowser post, where I list what is wrong with the CPI, the commonly-cited measure of inflation, and what should be done about it.

1) Why include rarely-purchased things in the CPI at all? If home prices double, that doesn't change my mortgage payments. (Rents, which do regularly shift for those paying them, are a different story.) If iPods can now store twices as much for the same price, that doesn't do anything for me until I replace mine in two years. It does even less if price increases keep me from making that purchase altogether.

2) About hedonic adjustments: Here, I'll have to admit not having done my research here, and the wikipedia article wasn't much help. In order to do such an adjustment, you'd have to look at the product and measure various characteristics about it, which doesn't sound like something the relevant commissinos have labs for.

Example: I've noticed cereal boxes have gotten flimsier and thus hard to hold. I know this wasn't done because the flimsiness is a hugely sought-after thang. It was because that's cheaper. In doing so, they gored my consumer surplus. Though still worth buying -- because I like cereal -- the box is worth a lot less to me. Was this factored into cereal prices?

Without lifting a finger to do research, I'm guessing the answer is somewhere between "no" and "HAHAHAHAHA! Good one!"

So then, do hedonic adjustments ever result in inflation being stated as being *higher* because quality went *down*? If no, that means they should be discarded altogether. Don't subtract quality improvements unless you're going to add quality degradations.

3) Why don't they compile an "insulin index" as a way to measure the impact of the money supply on general price levels? Insulin is a necessary product for diabetics, who use it to sustain their existence, consciousness, and general health. It is the only product I know of to meet all of the following conditions:

-Has a very fixed, inelastic demand.
-Has many inputs, making it unaffected by local supply shocks.
-Can't be degraded in response to more expensive overall inputs, since it needs to meet a medical standard, thus preventing inflation from being hidden.

I haven't been able to find such an index.

4) Not so much a CPI issue, but why have your "core" inflation measure be one that outright excludes the very vital food and energy from it?

Yes, food and energy are deceptively volatile.
No, that's not a good enough excuse when we have such mathematical tools as a "RUNNING AVERAGE" that allows you to eliminate short-term volatility, while also accounting for when those prices go up and stay there.

Paranoid comment-left-elsewhere of the day

There's been a lot of talk about whether you're money's safe in banks, and Jeffrey Tucker's recent post at the Mises blog ponders this. I've heard rumors from people at work suggesting that you need to at least make sure your money qualifies for the FDIC guarantees.

My comment:

If your friends are asking if they should worry about getting back their money that's in the bank, I'd say that's pretty ridiculous -- the FDIC will get it to them. The real concern you should be having is about the value of that money, and on that question, it really doesn't matter if your money's in an FDIC-insured account or not.

They'll get you, not by reneging on the FDIC's guarantee, but by making the money worthless when they finally get it back to you.

As always, it's not inflation that bothers me, but interests rates not reflecting it.

Couldn't have said it better myself.