Dan Sutter: The agony of inflation

Inflation is a big issue for voters. However, economists generally argue that the costs of inflation are excessive. Are these views compatible?

First, inflation, as measured by the Consumer Price Index (CPI), has fallen significantly since reaching 9.1 percent in June 2022. Inflation was 7 percent for the whole of 2022, but only 2.9 percent in July.

Also remember that inflation is the rate of change in prices. A decline in inflation means prices are rising more slowly. To return prices to 2021 levels would require negative inflation or deflation.

Economists usually think of “pure” inflation, that is, an equal percentage increase in all prices, including wages and salaries. So inflation of five percent means a five percent increase in prices for all goods, services and labor. The wage increases should offset the higher prices (ignoring tax implications).

An increase in the prices of just some goods is a change in relative prices. A 10 percent increase in the price of food, energy and transport could raise the consumer price index by five percent. Strictly speaking, this is not inflation, and since wages are not rising, people are worse off.

I think economists should focus on how inflation affects families. Understanding decisions from the perspective of the subjects of our analysis is a core element of economic research.

The Consumer Price Index (CPI) measures the cost of purchasing an average basket of goods that no household is likely to buy. The effective rate of inflation for households depends on the things they buy. Today, some are facing inflation of over 2.9 percent.

Raises do not automatically correspond with price increases, except for a COLA, or cost-of-living adjustment. COLAs adjust wages or salaries when the consumer price index increases. There are also COLA adjustments for Social Security benefits, but only about one in ten private sector workers are eligible for COLAs.

As a result, most workers are not guaranteed a corresponding raise. Inflation therefore creates uncertainty, which causes stress. In addition, many Americans' “raises” come from changing jobs, which in turn creates costs and stress.

A compensatory pay rise, if granted, will follow the price increase. Monthly budgets were still tight in 2022, even for those who received a seven percent pay rise at the end of the year. In the race to inflation, wages generally lag behind prices.

Many Americans do not save annually and have little savings accumulated. Higher prices for essential goods lead to difficult choices. Most economists can afford $100 more a month on groceries without getting a raise. We fail to recognize the burden that higher prices place on many families.

A change in the way the CPI is calculated could increase the divergence between measured and perceived inflation. Substitution bias has contributed to the CPI overstating the rate of inflation. The CPI basket of goods does not change monthly as prices rise and fall, but consumers will respond.

To illustrate, let's say that Coca-Cola and Pepsi initially sell for $4 a bottle. The price of Pepsi increases to $6 while Coca-Cola stays at $4. This represents a 25 percent increase in the average soda price. The impact on consumers is less than the 25 percent increase that results from raising both prices to $5. Many will replace Pepsi with Coca-Cola.

Starting in 1999, the Bureau of Labor Statistics began adjusting the Consumer Price Index (CPI) for the substitution effect, which makes sense. But consumers miss out on some satisfaction even if the substitution keeps budgets from exceeding the limit.

A final consideration is the supply chain disruptions caused by COVID and the lockdown. Shortages are causing significant economic problems in several ways.

To see desperate parents driving from store to store during the baby formula shortage. The time and gas spent searching increases the effective price of the baby formula when it is finally purchased. Unconsumed items reduce customer satisfaction. And scarcity creates uncertainty.

The prices required to keep certain items in stock provide one way to assess the impact of shortages. Measured inflation would have been well over seven percent if prices had risen that high.

Strictly speaking, these problems are due to scarcity, not inflation. But people are likely to associate them with recent inflation.

A simultaneous, equal percentage increase in all prices and wages might not be very painful. But that's not how inflation works. The realization that pain is felt highlights Americans' concern about inflation.

Daniel Sutter is the Charles G. Koch Professor of Economics at the Manuel H. Johnson Center for Political Economy at Troy University and host of Econversations on TrojanVision. The opinions expressed in this column are those of the author and do not necessarily reflect the views of Troy University.

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