CPI was flat. The futures were up this morning, and pundits were claiming that the CPI numbers were indicative that any recession will be shallow and short. After all, if prices aren’t spiking, the consumer will have an easier time. This analysis is flawed. This only indicates what everyone should know: CPI isn’t a leading indicator.
CPI isn’t a measure of inflation, despite what our government officials and popular media believe. Austrian economists define it best: inflation is an increase in money and credit. Deflation is a contraction of money and credit. The alternative, which is to measure prices, has far too many variables to be truly useful. I’ll go through some variables.
If all things are equal and the money supply increases, prices rise. That’s helpful. However, since everyone doesn’t get the new money at the same time, prices don’t rise evenly. The targets of government spending get money first. For the sake of argument, suppose the recipients of the new money are defense contractors. For them, the new money has the same purchasing power as old money. Prices haven’t risen. As the defense contractors spend their money, if they increase consumption, prices rise on the goods that represent the increased consumption. The sellers and producers of those goods now have access to that new money. Their purchasing power is slightly weaker than originally, but perhaps the increased money has actually increased their wealth. As they spend money, the effect continues. Consumption increases, prices rise, and new money makes its way into the hands of a broader cross-section of the population. But, the further down the chain a person is, the less the purchasing power of the new money. Those furthest from the money had to deal with increased prices for a while before getting access to the extra money. This is why some economists refer to inflation as a tax. It’s the most unfair tax, transferring wealth from those furthest from the money source to those closest to the money source. Note also that goods purchased by those closest to the money source have higher price increases than goods purchased only by those furthest from the money source. This complicated process is the first reason why simply measuring prices is not a good measure of inflation.
The second variable, poorly understood by anyone, is the issue of hedonics. A pound of beef purchased today is the same as a pound of beef purchased ten years ago. However, a television purchased today is significantly better than a television purchased ten years ago. Now think of computers now vs. ten years ago. How about cell phones now vs. twenty years ago? When measuring prices, you can’t simply use a fixed basket of goods, because consumer behavior changes over time, and the quality of goods changes over time. If the entry-level TV costs the same now as ten years ago, has the purchasing power of the dollar increased or decreased? Well, you could argue that the quality of the television has doubled, so the purchasing power has doubled, at least as far as TVs go. The government tries to compensate for this when preparing the CPI report, but it’s quite obviously not an exact science.
The third variable I’ll discuss is well understood. Prices drop when demand drops (this is seller-driven behavior). Also, demand drops when prices rise (this is buyer-driven behavior). When oil prices went too high, China and India cut their subsidies on oil. Americans actually drove less (it took us a while, demand proved to be inelastic for quite a range of oil prices). Demand for oil fell off a cliff. That caused prices to fall.
The issue of demand is important. We are experiencing deflation. Credit is contracting. As a consequence, a person living paycheck to paycheck actually has to make the choice between buying food and buying gas (or buying a TV, paying their bills, etc). Purchasing decisions are zero sum. This is how most basic economic theories actually work (economics as a science doesn’t require short term decisions to be zero sum). This is a different situation than many Americans faced a couple years ago. They could spend more than they made because of the magic home ATM. As long as home prices went up forever, even people living paycheck to paycheck could spend more than they made. In the long run, this is obviously not sustainable, and it has stopped. But the point is that the consumer actually has to make a choice now. The consumer can’t simply buy everything. Aggregate demand has fallen as a consequence.
This is why everyone who thinks this CPI report is positive is wrong. Demand has fallen. Prices are sticky because businesses are trying to hang onto high prices too much (times are tough for them, there’s a psychological barrier to price reductions). As unemployment rises (it will, despite today’s “good” jobless claims report), CPI will fall. Prices can’t fall far enough to make things easier on a consumer with no job. Low CPI doesn’t magically mean that times are good.
