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July 09, 2010

How close to deflation are we? Perhaps just a little closer than you thought

Since last October, the consumer price index (CPI) has gone up an annualized 0.7 percent. On an ex-food and energy basis, the number is a little lower, at 0.5 percent. And the Cleveland Fed's trimmed-mean and median CPIs, at 0.7 percent and 0.2 percent, respectively, also put the recent trend in consumer prices in pretty low territory.

And this is before we take into account any potential mismeasurement, or "bias," in the construction of the CPI.

How big is the CPI's bias? Well, in 1996, the Social Security Administration commissioned a study on the accuracy of the CPI as a measure of the cost of living. This so-called "Boskin Commission Report" said the CPI was overstated by about 1.1 percentage points per year. The commission identified several sources of potential bias, but about half of the 1.1 percentage points resulted from new products and quality changes that were slow or otherwise imperfectly introduced into the price statistic.

Since that time, the Bureau of Labor Statistics has initiated a number of methodological changes that have reduced the CPI's mismeasurement. In a 2001 paper, Federal Reserve Board economists David Lebow and Jeremy Rudd put the CPI bias at only about 0.6 percentage points. And again, of this amount, the big share of the bias (about 0.4 percentage points) resulted from the imperfect accounting of new and improved goods.

Now, in an article (available to all in its working paper version) appearing in the latest issue of the American Economic Review, Christian Broda and David Weinstein say the earlier estimates of the new goods/quality bias may be a bit understated. The authors examine prices from the AC Nielsen Homescan database and conclude that between 1996 and 2003, new and improved goods biased the CPI, on average, by about 0.8 percentage points per year. If this estimate is accurate, consumer price increases since last October would actually be around zero, or even slightly negative, once we account for the mismeasurement of the CPI caused by new and improved goods.

But (oh, you just knew there was going to be a "but" in here, right?) the authors also point out that, because new goods are introduced procyclically, this bias tends to be larger during expansions and smaller during recessions. In other words, given the severity of the recession and the modest pace of the recovery, there may not be a whole lot of innovation going on right now in consumer goods. This is a bad thing for consumers, of course, but it would be a good thing for the accuracy of the CPI.

By Mike Bryan, vice president and senior economist at the Atlanta Fed

July 9, 2010 in Deflation, Inflation | Permalink


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This study is good, and should displace many of the big numbers floating around.

But it does not look at the even bigger problem that the CPI home owners equivalent rent probably significantly understates home prices increases over the last 30 years.

Posted by: spencer | July 09, 2010 at 05:28 PM

Changes in the economy of the upcoming dimension are impossible to not see.

Contrary to economic theory and Nobel Laureate Milton Friedman, monetary lags are not "long & variable". The lags for monetary flows (MVt), i.e., the proxies for (1) real-growth, and for (2) inflation indices, are historically, always, fixed in length.

It is an incontrovertible fact (as it now stands), that nominal gDp will cascade through-out the 4th qtr (down in every month - Oct, Nov, & Dec). And without a slingshot (added monetary & fiscal intervention/stimulus), the economy will never "reach escape velocity".

Stocks will crash by Oct. - at the latest. They will probably correct back to the right shoulder at 6,547. The bottom for this depression is in July 2011. The DOW will bottom c. 3,300.

Posted by: flow5 | July 11, 2010 at 02:43 PM

The idea that the CPI overstates inflation is open to interpretation. Various statistical measures may be applied to show that the CPI does in fact overstate the inflation rate. However, the way the CPI measures inflation is in stark contrast to the perceived value consumers place on the goods and services they purchase. If for instance a new automobile has added one new feature over last years model of that same vehicle and the added worth to that vehicle is $500, and this new feature is standard for the new model, and the price to the consumer for the new model is only up by $200; then the CPI would say that in this case not only was there no inflation, but there was deflation that took place. The consumer purchases the new vehicle thinking that he paid $200 more than he would have paid for last years model and that inflation in this case had risen for the new vehicle. So he pays more for the new vehicle that came with an added feature that came standard (meaning he had no choice on the added feature)and is told by CPI standards that he actually paid $300 less than his actual cost outlay.
This may sound reasonable to an economist, but not to the average consumer.

Posted by: JRB | July 15, 2010 at 10:53 AM

"This may sound reasonable to an economist, but not to the average consumer."

Ya but this is not typically what happens. Usually prices stay constant and features increase or sometimes prices even fall and features increase. I remember buying my 1998 Corolla for more than the current 2010 Corolla and with fewer features. Additionally I know that the quality has improved.

Its obvious this is deflation. In fact its gotten to the point that I try to delay purchases as long as possible because I know the later I buy the higher the quality, the lower the price and the greater the features.

Posted by: assman | July 16, 2010 at 09:21 AM

Hey, what happened to the post on the Beveridge curve? I was going to leave a comment, but it disappeared.

Part of the comment is relevant to this post though: since Beveridge curve shifts are correlated with Phillips curve shifts, if the latest observation really represents a shift, then it may mean we are not as close to deflation as I thought (but I thought we were pretty damn close, even before reading this post). 4 years ago, I never would have thought that an increase in the NAIRU could be good news, but under the circumstances, it might be.

Posted by: Andy Harless | July 16, 2010 at 11:20 AM

The problem in this analysis, of course, is that the CPI is underweight in THE THINGS THAT PEOPLE MUST BUY.

So for me, comfortably middle class, the CPI is probably high. For people who struggle, it is low. The fact that my eventual heart bypass surgery will be a technological marvel will be small consolation for the family of four that barely misses qualifying for public assistance.

Posted by: Robert in Phoenix | July 17, 2010 at 08:34 PM

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