Measuring Inflation? You Try Setting the Rules!

by: Jeff Miller

We are continually amazed at the difficulty in stimulating anyone to re-consider 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 answer 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.