Inflation is currently running rampant in the US and around the world. The Bureau of Labor Statistics (BLS) released that as of May 2022, inflation in the US was up 8.6% year over year. But what does that mean?
Many people point out that they’ve observed prices rising even faster. One person on Reddit posted they feel the “real” inflation is actually 25%. But what could they possibly mean by that? The best interpretation I can come up with is that they feel their personal expenses have risen 25% for the same items over last year. And maybe that’s true, but that’s not how inflation is measured.
That may be surprising, so let’s take a step back and start from the basics. How IS inflation measured? (Note: this will be highly simplified and is missing some nuance, but it gets the most important features).
Apples and Bananas
Let’s start with a simple case and build from there. Imagine all prices for all goods and services stayed exactly the same except for two items: apples and bananas. (Let’s further assume that all varieties of apples and bananas cost the exact same price and rose by the same amount). Apples went from $1 each to $1.10 each, while bananas went from $0.50 each to $0.60 each. That’s a 10% increase for apples and a 20% increase for bananas.
How does one calculate inflation here? You may be a person who doesn’t eat much fruit, so your expenses don’t go up at all. You may be someone like me with a toddler at home who loves bananas and buy a bunch twice a week. You may be allergic to bananas, so you only eat apples.
The way inflation is calculated is that the BLS sets a basket of goods based on the results of “Consumer Expenditure Surveys” and the price of that basket of goods is tracked in an index called CPI. Changes in this index over time are reported as inflation. If apples and bananas each make up 1% of the basket of goods, then inflation would be calculated as 0.3%, for example.
But wait, there’s more. The BLS takes other factors into consideration. First, what if, through genetic engineering, apples just taste better than they used to, and that’s why the price is up 10%? The CPI includes “hedonic adjustments” to the prices to account for this.1
Also, to what extent can apples be substituted for bananas and vice versa? Can you add apple slices to your peanut butter and jelly sandwich rather than banana slices? What about ditching both apples and bananas and switching to avocados? The CPI accounts for this through a “geometric means formula,” the details of which are beyond the scope of this post. So in our example, assuming some substitution, inflation may be reported as lower.
What does it all mean?
It should now be obvious that the reported inflation rate has nothing to do with what you personally spend. The effects of inflation are highly heterogeneous. This has important real-world ramifications that policymakers need to take into consideration.
First, different groups can get hit harder by price increases than others. The current baby formula shortage, for example, has driven formula prices up, harming parents disproportionally. Another example is the so-called “pink tax,” in which products marketed to women cost more than identical or nearly-identical products marketed to men. An increase in this effect would be inflation, but not for everybody.
Additionally, even within a group, some individuals can be hit harder by inflation than others. So while the average person might spend somewhere around 8.6% more on goods this year than last year, that number can vary wildly. One person may be able to substitute their goods such that they see no increase in expenses. Another person may face an increase of 50% in their expenses. The impact won’t be distributed normally or symmetrically around that 8.6%
It’s also worth noting that the CPI data only comes from urban consumers. Suburban and rural consumers are not taken into account.
So, what is the inflation number good for, then?
It’s a mathematical construct that can be used to inform policy decisions in addition to many other factors. That’s it. Perhaps instead of a percent, they could scale it to be a plain number to avoid confusion. If they said that the year-over-year inflation index was 86 when it is normally around 10 to 20, it would convey the fact that inflation is much higher than normal without all of the psychological baggage of seeing a percentage and interpreting that in light of one’s own life experience.
In the real world, apples are not subject to hedonic adjustments (see item FK011 on this table).