Inflation numbers are nearly meaningless during the pandemic

What’s the right inflation basket for a lockdown?
What’s the right inflation basket for a lockdown?
Image: Reuters/Daniele Mascolo
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The value of a dollar is going up. At least that’s what the consumer price index (CPI), the US government’s headline inflation metric, indicates.

The US Bureau of Labor Statistics announced last month that CPI declined by 0.42% in March—the largest decline since January 2015. CPI attempts to measure the change in the cost of a typical basket of goods that an American buys in an average month. A decrease in CPI suggests that a dollar goes further in what it can buy (deflation), while an increase means a dollar is worth less (inflation). A small amount of inflation is the norm, with prices rising somewhere between 0.1% and 0.3% in a typical month. Prices going down by more than 0.4% is strange.

It’s probably a mirage.

The largest driver of the decline in CPI was plummeting energy prices, which accounted for about three quarters of the fall. Other goods that got significantly cheaper were new and used vehicles, airline prices, household furnishings, and apparel. I don’t know about you, but I am not spending a lot of money right now on gas, airplane tickets, and new outfits.

This coronavirus pandemic is drastically changing what Americans are purchasing. Each month, the US Census estimates how much money was spent at different types of retailers. The data show that spending at car dealers, restaurants, gasoline stations, and clothing stores dropped precipitously in March 2020 compared to the same month in 2019. These types of retailers are almost certain to struggle for many more months, as people try to maintain social distancing.

Though people’s purchasing habits are changing quickly, the basket of goods used to calculate CPI is not. The components of the CPI basket of goods are chosen based on a survey of consumption habits from at least two years earlier. That means that inflation, as measured by CPI, doesn’t reflect reality. The drop in the price of gas and new clothes does not really mean a dollar is going further for most people, since that’s not what they actually want to buy right now.

Even before the pandemic, many economists considered CPI a flawed measure. Besides the lag in updating the basket of goods, it also does a poor job of accounting for “substitution effects.” If apples become expensive and pears don’t change in price, many people are happy to substitute pears for apples when they do their grocery shopping. CPI’s formula doesn’t consider this willingness to swap out similar good for one another.

The other most popular measure of inflation, the personal consumption expenditure index (PCE), does account for the ability to substitute products. The formula for PCE inflation also allows for the basket of goods to change more quickly.

As a result, the PCE index only went down by about 0.27% in March 2020—about two-thirds of the decline of CPI. Still, the deflation shown by PCE is likely still an exaggeration because it doesn’t immediately adjust in full to changes in spending habits.

Inflation is always challenging to measure. In the pandemic economy, it’s nearly impossible.