A Real Measure of Inflation

As most of us are aware, the Federal Reserve dreads the prospects of both deflation and inflation.  The Fed has determined that inflation at the rate of 2 percent, as measured using the annual change in the price index for personal consumption expenditures, is most consistent with the Fed's goals of maintaining both stable prices and maximizing employment.  When inflation goes above the target rate, the Fed gets concerned about the long-term economic health of the nation.  When inflation goes below the target (or becomes deflation), consumers may find that their wages are dropping along with prices, causing them to postpone purchases which results in an economic slowdown.

Rather than using the normal Consumer Price Index or CPI, researchers at the American Institute for Economic Research (AIER) have developed a measure of inflation that they call the Everyday Price Index or EPI.  The EPI measures the day-to-day changes in the price of goods and services that people purchase most frequently; these goods and services are purchased at least once every month.   These items include food, utilities, gasoline, personal care products, motor vehicle insurance, various recreational expenses including cable fees and club dues, communication costs and costs of prescription drugs among others.  Unlike the CPI, the EPI deliberately excludes infrequently purchased good including automobiles, computers, electronic goods and payments that are fixed in size by contractual arrangements like rent and mortgages.  Each of the components in the EPI is then weighted by the share of expenditures that it consumes which are equal to the weights used in the Bureau of Labor Statistics CPI calculation.  The EPI is also not seasonally adjusted, rather, it reflects the actual prices paid by consumers.  Most importantly, as you'll note, the EPI assumes that a larger share of household budgets are consumed by energy costs, something that most of us can attest to.  In a world where energy prices are extremely volatile, particularly to the upside, it is quite obvious that increasing costs of energy can have a detrimental impact on household budgeting.

Here is a chart showing the expenditure categories and weights used in calculating the EPI:

As we can see from this chart which shows the increases in prices for each of the components since 2000, the motor fuel component (in black) is by far the most volatile:

Other than motor fuel, the greatest price increases over the decade and a half have been seen in prescription drugs and medical supplies which has increased by 60 percent, auto insurance which has increased by 68 percent, cable and satellite television services which has increased by 58 percent and by fuels and utilities which have increased by a rather hefty 80 percent as shown on this graph:

As shown on this graph, the lowest price increases over the decade and a half have been seen in food at home which has only increased by 42 percent, food away from home which has increased by 48 percent, alcoholic beverages which have increased by 37 percent and club memberships which have increased by 21 percent as shown on this graph:

Let's look at a graph that shows how the CPI (in red) and EPI (in blue) compare over the period from 1987 to the present:

You'll notice that, over the long-term, the EPI suggests that inflation has been far worse in the "real consumer world" than the CPI would suggest.  This is not terribly surprising, particularly given that the CPI includes only goods and services that are rarely consumed.  I think that most consumers would agree that inflation has been far worse than what the headline numbers would suggest. 

In the month of September 2014, the EPI actually decreased by 0.2 percent compared to a 0.1 percent increase in the CPI.  This is because, for the third straight month, the price of gasoline dropped.  The price of home heating oil and electricity also dropped resulting in a total decrease in energy prices of 1.5 percent.   As a result of increases in food prices in September, much of the decline in energy prices were offset.  In particular, the prices of meats rose because of the drought and a deadly swine virus.  

On a year-over-year basis, the EPI increased by 1.6 percent compared to a 1.7 percent increase in the CPI, both of which are below the Federal Reserve's target.  Over the past year, energy prices have been mixed with gasoline falling by 3.6 percent, electricity rising by 2.8 percent and natural gas increasing by 5.8 percent.  On the food side of the equation, the price of pork has risen by 20 percent, the price of beef has risen by 17.8 percent and the price of butter has risen by 23 percent.

It is interesting to see that both methods for calculating consumer price inflation suggest that inflation is coming in below the Fed's target rate.  While we are not in a deflationary environment, if fuel prices continue to drop, the Fed may have to resurrect some form of its monetary policy experiment to counteract a central banker's greatest fears.