Measuring Inflation? You try setting the rules!

At " A Dash" we are continually amazed at the difficulty in stimulating anyone to reconsider existing opinions.  This seems especially true on the subject of measuring inflation.  There are plenty of self-proclaimed experts.  Taking a step away often helps us shake off biases and get a fresh look at the problem.

Here is a little test.  Try to give an honest answers to each question below.  We shall suggest the relevance in the conclusion.

Measuring Inflation and Related Concepts

Here are a few interesting situations related to inflation measurement concepts.  Please take a moment to make an actual answer to each question.  Doing so will make the experience much more valuable.

  1. A company comes out with a new package size for a product.  The size is 50% larger and the price goes up by 25%.  Should we view the price of the product as lower, unchanged, or higher?
  2. The price of homes is going up, but interest rates are moving lower.  One person sells an existing home and buys another.  Both homes increased by 20% in price during the prior year.  The second person remains in the same home with the same mortgage, living next door to a place that went up by 20%.  The third person, who also lives next door, refinances his mortgage to pay off the loan much more quickly with the same monthly payment.  Two of the three people are paying no more for their housing, although the home price went higher.  One is paying of the mortgage faster.  How would you measure the increase in home prices, given the decrease in payments?
  3. You are told that a group of 24 other countries has adopted some rules about private accounting.  (Forget things like FAS 157 and marking to market — those are out!  International accounting does not follow these rules.)  Do you think that this is a good argument for U.S. accounting to follow suit?  What if the other countries had different rules about free speech?  About voting?  About religion and education?  Briefly put, does the fact that a group of other countries does something mean that the U.S. should also, without regard to the actual values and merits?
  4. Let us suppose that the price of a car in year X is $15,000.  A few years later the car has the following improvements:
    • Anti-lock brakes — improving safety.
    • Side bars to protect in side collisions.
    • Air bags to protect in frontal collisions.
    • Fuel injection and computerized sensors to improve fuel economy.
    • Stronger and safer tires.
    • A life expectancy of 150,000 miles instead of 50,000 for the earlier car.
    • Better cup holders, including both warming and cooling.
    • If the car still sold for $15,000, would you say that the actual price had decreased or remained the same?
  5. You are trying to measure recreation costs for a typical Chicago family that likes sports.  The Bulls use their #1 draft pick to choose the next Michael Jordan.  To help with costs, they raise ticket and concession prices by 30%.  You give up your Bulls tickets and instead buy more tickets to the Bears, marked down after failing to get a Quarterback in the draft and releasing their top running back. You spend the same amount of money to watch football instead of basketball.  Has there been an increase in the price of recreation?

A Second Look at the Bill Gross Argument

If you gave honest answers to the questions above, you are now qualified to read (again?) the Bill Gross commentary that got so much buzz.  We suspect that few read it carefully the first time, and fewer still read it with a critical eye.

See if the conclusions have the same black-and-white quality that they did when cited in the media.  We shall continue this series with our own analysis.  In particular, we shall review how actual economists (as opposed to non-economist pundits and fund managers) look at these problems.

Inflation measurement is central to many current economic and market questions.  As we have noted, it is important to use unbiased and authoritative sources.

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  • Mike C June 11, 2008  

    Here are my honest answers and I think they fall on both sides of the argument:
    1. Lower. The price per unit has gone down as the increase in size is larger then the increase in cost.
    2. Hmmmmm… First thing that pops in my head is should the financing of a purchase be conflated with the actual sticker price of the purchase. Anything can be purchased on credit. One can go to the grocery store and buy steaks, eggs, and milk and throw it on the credit card. Obviously, very few people pay cash for their houses so financing is part of the equation for most, but I’m not sure what is the “right” way to measure this. If I buy a stock on margin levered 2:1 how do I measure my rate of return? No easy answer here IMO.
    3. Briefly put, does the fact that a group of other countries does something mean that the U.S. should also, without regard to the actual values and merits?
    No, but if you are completely different from the rest of the group, I think it behooves trying to figure out why. You could be right and the other 20-25 wrong, but the magnitude of that disparity suggests the opposite may very well be true.
    4. If the car still sold for $15,000, would you say that the actual price had decreased or remained the same?
    No doubt whatsover, DECREASED. But isn’t there potential for funny business here in terms of magnitude. Maybe the improvements deflate the price to 13.5K or 12.5K, but what if I say the improvements deflate the price to 1K? Would that pass the smell test? How do we put a numerical quantity on a qualitative improvement without overstating it?
    5. Has there been an increase in the price of recreation?
    Not sure. A wash? This could get tricky as well though. Al Pacino and Robert De Niro are in town acting in a play that costs $500 a ticket to see. A group of parents set up a play next door starring their kindergartners and toddlers for .25 a ticket? Has the cost of recreation in town just plummeted?
    I try to stay open minded to reconsider existing opinions which is why I read this blog, and did try to think hard about these 5 questions. It seems completely sensible and logical to make hedonic and substitution adjustments but the magnitude could get tricky.
    Maybe I’m slow, but I’ll repeat my question that went unanswered which is what is Bill Gross’s vested interest/agenda here? Just my opinion, but if you throw something out there like this:
    “Big-name fund managers like Bill Gross have a strong financial interest in public perception of inflation and the economy. Like any smart manager, he talks his book.”
    and somebody asks about it, then an answer is probably warranted.

  • Lanny June 11, 2008  

    1) Lower
    2) Since housing expense ratio to price remained constant, there is no change in housing price.
    3) No. To make it an obvious answer just assume all the countries are like Iran.
    4) What is the cost to build the car in year X and the cost to build the car today? What is the utility rate ratio then and what it is now? (What I mean about utility rate ratio is the same level of a medieval king’s comfort levels measured against Bill Gate’s today with the exception that a king can kill anyone at ease but Bill Gate can’t – But that exception is also need to to take in account too)
    Absolute cost is not meaningful unless we have some benchmarks to measure against it.
    5) Increase. They have to lower your expectation because of price. Same thing as you go to a cheaper restaurant because you can’t afford your previous restaurant due to price increase. Now if they already have Michael Jordan then it would be a different question and answer.

  • Lord June 11, 2008  

    1) Lower
    2) Unchanged to first order. Higher property taxes would increase it though.
    3) No, but it is worthwhile considering and possibly even reporting on comparable basis.
    4) Decreased, but this should be evident on resale. If it still depreciates as fast, than it would not have decreased since those improvements have become obsolete faster.
    5) Increase unless the fall in Bears tickets offsets the increase in Bulls tickets. Only being able to afford an inferior product does not mean prices have remain unchanged.
    For those who think inflation has been much worse, I ask them how much their pay has increased. When they say by less, I ask them where they have cut back. If they are unable to identify where, I conclude it is by less than they think.

  • Lord June 11, 2008  

    One can be tricky since larger sizes are normally cheaper. It would also be worth comparing with larger sizes if possible to see if there wasn’t in fact an increase.

  • RB June 11, 2008  

    Excellent and thought-provoking post.
    1. Difficult to say — if only the 50% bigger package was available at 25% higher cost, it may still be 25% higher than I want to pay. It may also not reflect lower pricing if all that occurred was reducing the effect of a fixed cost. I would not use it in an inflation measure if this was all the information I had available.
    2. I would look at the cost of servicing house payments by linking to the OFHEO index.
    3. Easy question, the answer to which is no.
    4. Difficult to say — if based on an inflation index that is considered generally acceptable there was inflation over the few years, the cost went down. If there was deflation, the answer is tricky, especially if the original version is not available for purchase currently.
    5. If the family that likes sports likes both games equally, its cost went down. If both games were filled to capacity with such typical families, the cost of recreation went up.

  • SI June 12, 2008  

    1. Depends on what is called as “least count” in physics for the measurement. The price has gone up if the smaller packaging is discontinued, if both options are available the price has gone down. Consider examples –
    I only need one Advil, but Walgreens will only sell me 25 for $5. The price of One advil for me is $5, not $0.20 as the “least count” is 25. The price of 26 Advils is $10, not $25.20
    The test here is – will they give me “just one” if I offer anything less than $5 ?
    2. Increase in “home price” = 20%, as that is the current price of the SAME home.
    Mortgage is the cost of a loan. The amount of the loan was equal to the price of the home in the past. The “mortgage” is only connected to your financial obligation. Home price cannot be measured by mortgage outstanding.
    3. Majority opinion does not change facts. Democracy is not a great way to make policy. Enlightened dictatorships are better, however the problem is that most dictators are, or turn into, despots.
    4. See #1. If the original car is available for $7000, then price has fallen, else price has remained the same. You can only compare like things, but if today’s worst car is better than the car from 1950, we need to use today’s worst car as today’s price, not some hypothetical “worse than the worst car in the market” which cannot be bought.
    5. Yes there has been an increase in entertainment expense – I am getting less entertainment for the same money.
    My first choice was Bulls, which now costs more.
    I am opting for my second choice Bears, which used to be cheaper earlier.