In June 2022, inflation reached a high of 9.1% compared with the year before – a level not seen in the U.S. in 40 years. Recently, there has been a lot of talk from Washington, D.C., about the decline in inflation down to the most current reading of 3.7% from a year ago – and yet, at the same time, people still aren’t seeing relief in their monthly grocery bill. How can both of these things be true at the same time? It’s because inflation is a measure of the rate of change in the general level of prices and not the general price level itself. To understand how inflation can be falling and prices still high, one needs to understand how inflation and the general level of prices are calculated.
The consumer price index is calculated by the U.S. Bureau of Labor Statistics from a market basket of different goods and services whose prices are tracked from month to month. This market basket consists of typical household expenses throughout the year: rent and utilities, food and beverages, airline tickets, gasoline, clothing, doctor’s visits, etc. And the cost to acquire this identical market basket every month is calculated. Inflation is how much the cost to acquire this market basket has changed from month to month or year to year, depending upon when you want to measure it.
If the price of all the items in our market basket goes up 10% in 2022 from their 2021 price, then we will record an inflation rate of 10% in 2022. If these higher prices in 2022 don’t change in 2023, then we will record an inflation rate of zero in 2023 since there was no change in the cost to buy the items in our basket in 2023 versus 2022. Therefore, despite that fact that our market basket is more expensive today than it was in 2021, it will appear that inflation in 2023 is zero.
To add further insult to injury, in some months and years, the cost of some items in the basket – coffee, for example – might fall while others, like bread and apples, rise. Since some of the items in the CPI market basket are declining in price, the total cost to buy all of the items in our basket will be slightly less than it otherwise would have been, making it appear that inflation is not as high. In this case, if you purchase lots of bread and apples and no coffee, the cost to you of going to the grocery store and purchasing your own private market basket of goods will be rising faster than the reported inflation rate. Let’s say the price of milk and other dairy products increased 16% in 2022 while the price of books has stayed relatively constant, meaning the rate of inflation for books alone is close to zero. So, if you are a lactose-intolerant bookworm, inflation doesn’t seem that bad compared with someone else who drinks 3 gallons of milk a week.
What does this mean for us going forward? We can probably expect inflation to slowly fall over the next few years back to the Federal Reserve’s target rate of 2% all while continuing to see the high prices we have today. The prices of milk, hamburgers, apples, etc., are not going to fall back to the level they were in 2020. Furthermore, inflation unfortunately can also become a psychological phenomenon once people begin to expect it. Workers, rightfully so, begin to demand higher wages to compensate for the higher cost of daily living since their take-home pay now buys fewer goods and services. Of course, companies, rightfully so, now pass on these higher labor costs to produce their products on to consumers in the form of higher prices – which triggers employees to once again ask for another round of cost-of-living increases in their pay. This explains why inflation can be so nefarious. Once the idea of higher inflation gets planted in consumers’ minds, it in essence becomes a self-fulfilling prophesy. In short, we all help to create the very inflation that we loathe.
David Mitchell is an economics professor at Missouri State University and directs the school’s Bureau of Economic Research and Center for Economic Education. He can be reached at firstname.lastname@example.org.
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