Inflation Rate Models Make a Difference

AMA4-26-15Inflation is a word that strikes dread into the hearts of American consumers, who know that when it’s headed their way, their hard earned dollars will buy less. But different models of measuring inflation can make a big difference in how scary those numbers can be.

Inflation and its opposite number deflation have been around for a long time. The Bureau of Labor Statistics began compiling data from the Consumer Price Index back in 1913, and a new report from Business Insider tracks it even farther back – all the way to 1872.

Thpse figures reveal some dramatic swings in the purchasing power of a dollar over a century and more of reporting. That period covered two world wars and the Great Depression, which account for some of the extremes in inflation and deflation during the twentieth century.

The years of both World Wars saw a not surprising spike in inflation, followed by a period of deflation. And the Great Depression saw the deepest deflation of all. In between those historic events, the pendulum still swung from inflation to deflation, but on a much smaller scale.

In the 1970s and 1980s the country struggled with a new phenomenon – stagflation, characterized by both a stagnant economy and stubborn inflation. The years post-2000 show modest inflation, holding at a ten year moving rate of just 2.22 percent, which is just about at the 2 percent mark that the Federal Reserve considers “acceptable” to keep the economy humming along.

Overall, though, as Business Insider points out, all this accumulated data reveal that in the past half-century and more, the purchasing power of the dollar has steadily declined. Those numbers are based on inflation rates calculated by the Consumer Price Index, which determines inflation rates by tracking the amount of real money it takes to buy a fixed amount of tangible goods at any given point.

But those numbers aren’t absolute – and different models for determining inflation rates can yield up inflation rates that are either higher or lower, which affects both everyday consumers and policy makers who adjust economic and monetary policies based on those rates of inflation.

For the purposes of calculating the inflation rates that drive both public policy and consumer decisions, there are two types of inflation: headline inflation and core inflation. And the outlook on inflation can be either brighter or gloomier; depending on what model is used.

Headline inflation is the general model that consumers are aware of: the purchasing power of the dollar relative to a set amount of all goods and services consumed. That includes the prices of fixed commodities as well as those that fluctuate in price, such as food and energy.

Core inflation, on the other hand, reflects the rate of inflation for fixed commodities only, while excluding energy and food. For that reason, some financial experts and economists believe that calculating inflation rates in terms of core inflation is more accurate, since it reflects a fairly stable set of commodities.

Others beg to differ. Market watchers including regional Federal Reserve President James Bullard of St. Louis argue that failing to take into account those volatile goods offers skewed numbers to consumers and compromises the credibility of the Federal Reserve. Still others call for developing other models for calculating inflation that take into account such factors as the “relative price” of goods where spending more on one item means spending less on another.

Headline inflation calculations reflect the fact that energy and food make a significant dent in the budget of most consumers. But because the prices of those things can fluctuate wildly due to factors ranging from climate events to armed conflicts and even changing consumer preferences, core inflation numbers might give a more stable indication of trends in inflation.

The CPI and Bureau of Labor Statistics inflation calculations aren’t just for the benefit of consumers, though. Those trends are watched by the Federal Reserve and other policy makers who use them to make decisions about monetary policy and other kinds of legislation. That’s why s financial experts like Bullard and others are calling for closer examination of just how inflation is really calculated and what that means to everyday consumers and national policy decisions.

Whatever the calculation, inflationary cycles are a fact of financial life. And, in fact, a little inflation is often a good thing – witness the efforts by the world’s leading economies, including the US, to keep inflation within an optimum range, rather than trying to eliminate it.

But because there’s more than one kind of inflation, consumers and money managers of all kinds may want to take the CPI’s current calculations with a grain of that volatile commodity – salt. (Top image:Flickr/donbrown)

Read more from The American Monetary Association:

What’s Behind the World’s Debt Crisis?

The Wizard of Oz: An Economic Fairy Tale?

The American Monetary Association Team

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