Inflation is Higher Than You Think

Just under a year ago we wrote an article on the posted inflation rates. That article can be found here. Now that 2018 is in the rear-view mirror, we thought we would look at inflation with a new set of stats.

Before we get ahead of ourselves, lets make sure everyone understand what inflation is. “Inflation is the measure of the average rate of price increase of a basket of goods and services in an economy increases over a period of time.”

In other words, inflation measures price increase.

Inflation for the 2018 calendar year finished at roughly 2.3%. 2018 inflation fits well within the 1.5-2.5% average inflation.

This means that in 2018, the price of the products and services in “the basket” increased by an average of 2.3%.

This hypothetical basket of goods and services is called the Consumer Price Index (CPI). The CPI is the most widely used measure for inflation.

If you would like a detailed breakdown of what is included in the hypothetical “basket of selected goods and services”, it can be found here.

The 8 categories of the Consumer Price Index (CPI) are: Transportation; Education and Communication; Apparel; Housing; Food & Beverages; Medical Care; Recreation; Other Goods and Services.

The CPI is widely considered the best measure of inflation. However, few actually know that the composition of the CPI changes. The weighting of the baskets of goods that make up the CPI is updated on a monthly basis, as seen here.

Furthermore, the way that CPI is now calculated has also changed throughout history.

Continuing on, we will go a little deeper into some of the perceived issues and controversies with the CPI.

Controversy #1: Exclusivity

Although the CPI is widely used and referenced, it is quite exclusive with who it includes. The CPI includes the following groups:

  • residents of urban or metropolitan areas,
  • including professionals,
  • self-employed,
  • the poor,
  • the unemployed, and
  • the retired.

Sounds inclusive until you realize who it is all excluding. Below is a list of all those not included:

  • rural or non-metropolitan areas,
  • farm families,
  • members of the armed forces,
  • those in prisons, and
  • those in mental institutions.

Not including these people is a limiting factor to the effectiveness of the CPI. For example the cost of food in rural areas is often significantly higher than in metropolitan area.

If we look at remote communities (especially northern Canadian communities) these food costs are astronomically higher. However, since they are a rural community they are not taken into consideration for the CPI. This is especially concerning because food is the second highest component of the CPI behind housing.

Controversy #2: COGI vs. COLI

When the CPI was originally created it was used to measure the cost of goods in one period of time versus another. At its inception it was a Cost of Goods Index (COGI).

However, over time changes have been made. It was decided that the CPI should reflect the changes in the cost to maintain a certain standard of living. These changes have started pushing it towards becoming a Cost of Living Index (COLI).

This is significant because a Cost of Living index has little statistical value when calculating inflation.

Controversy #3: Calculation Changes

Since the inception of the Consumer Price Index, there have been changes in the way calculations are performed. The changes were made “to eliminate biases”.

The new methodology takes into account the change in quality of goods. It also takes into account substitution.

Substitution refers to the change in purchase patterns by a consumer due to price changes or other variables. For example, if beef prices increase, consumers may opt to substitute a cheaper options like chicken or pork for a larger portion of their nutritional consumption.

Now that CPI takes substitution into account, it changes the weighting of those goods relative to other goods in the basket.

Taking into account substitution, this generally allows CPI to report lower inflation rates. Not only that but it also assumes that all consumers have access to suitable substitutions.

Having the ability to substitute necessities is not available to everyone. People living in rural areas, remote areas, or under the poverty line do not always have this luxury. But as we mentioned before, people in rural areas are not considered in the CPI anyways.

Conclusion

Although CPI is currently the most widely used measure for inflation, it comes with its own set of flaws that can be misleading.

However, the use of CPI to measure inflation should not be completely discarded. There are still some valuable insights that it provides. One such insight is; it acts as a gauge for measuring the way consumers react and behave when faced with increasing price trends in a particular category or sector.

Lastly, we haven’t yet developed a simple and widely accepted system for measuring price inflation across the entirety of an economy. For now, CPI will have to do!

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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy.

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