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“The back story on front page economics.” These accessible essays cover the basics ofeconomic topics, with a separate version for use in the classroom. Special “Focus onFinance” essays cover personal finance.

OCTOBER 2015

Inflation is when you pay fifteen dollars for the ten­dollar haircut you used toget for five dollars when you had hair.—Sam Ewing, Former professional baseball player

Does a dollar go as far as it used to? It might seem that you’re paying higherand higher prices for the goods you buy. However, the data show that inflationhas been virtually nonexistent for much of 2015. And the inflation rate has beenlower than the Federal Reserve's 2 percent inflation goal for more than 3 years.Nevertheless, when many people hear reports of lower­than­average inflationrates, they may not feel it reflects their experience as consumers. Where is thedisconnect between the experience of individuals and what the data show?

What Is Inflation?

What’s in Your Market Basket? Why YourInflation Rate Might Differ from the Averageby Scott A. Wolla

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10/8/2015 What’s in Your Market Basket? Why Your Inflation Rate Might Differ from the Average ­ Page One Economics ­ St. Louis Fed

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Generally speaking, inflation means the average level of prices is rising. Morespecifically, inflation is a general, sustained upward movement of prices forgoods and services in an economy. Prices have tended to rise over time, whichmeans that the inflation rate (the percentage increase in the average price levelof goods over a period of time) has been positive. And, as prices rise, thepurchasing power of each dollar diminishes. A 2 percent inflation rate meansthat (on average) a dollar buys 2 percent fewer goods and services than it didlast year. You might be surprised to discover that even after accounting for theeffect of rising prices (inflation), average incomes have risen over time. So,while it’s true that prices generally rise over time, so do people’s incomes, whichusually allows them to purchase more goods and services.

Even though you rarely find people discussing rising prices as an economicbenefit, most economists believe that a low and stable rate of inflation isbeneficial for the economy. To this end, many central banks have a mandate ofprice stability, which means they are directed to intentionally generate a lowand steady rate of inflation. The Federal Reserve System, the central bankingsystem of the United States, has a dual mandate of price stability andmaximum employment and has interpreted price stability as a 2 percent inflationobjective.

How Is Inflation Measured?

Inflation can be measured in a variety of ways, depending on which “basket” ofprices is measured and how those prices are weighted. The most widely reportedmeasure of inflation is the consumer price index (CPI). The CPI measures theaverage change over time in the prices paid by urban consumers for a marketbasket of consumer goods and services. The current CPI market basket wasconstructed based on input from spending diaries kept by 28,000 consumersand another 60,000 quarterly interviews conducted in 2011 and 2012. All thisinformation was used to determine what people were actually buying. Datacollectors visit places of business to collect price information monthly to recordthe prices of about 80,000 items that make up the market basket. The prices ofgoods and services in the market basket are then “indexed” to make it easier tocompare changes in the price of the market basket over time. To do this, theBureau of Labor Statistics sets the price of the market basket during a particulartime period equal to “100.” Changes in the index value are used to measureinflation and calculate the inflation rate. For example, if the index rises from 100to 103 in a year, the inflation rate for that 1­year period is 3 percent. Also,notice the use of the word “urban”; the CPI is meant to reflect the purchases ofthe typical urban consumer, which represents about 87 percent of the U.S.population. People who live in rural nonmetropolitan areas, farm families,people in the armed forces, and those in institutions are not included in thecalculation; therefore, the CPI does not attempt to reflect price changes forthese consumers.

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Your Personal Inflation Rate

Statistics are often reported as an average, but that average might not reflectthe experience of any given individual in the sample. For example, the averageage of a person living in the United States is 37.6 years and the average incomeis $46,163 (personal income per capita). Are you 37.6 years old with anincome of $46,163? Chances are you don’t fit this average exactly. Similarly,your personal inflation rate will likely differ from the CPI inflation rate. The CPImarket basket is an average calculated to reflect the spending of the averageurban household, not any specific individual household.

Because each individual buys a different basket of goods and services, potentiallyevery person has his or her own inflation rate. Your personal inflation ratedepends on how you spend your money. For example, let’s assume you hit the“average person” mark fairly closely: You are about 37.6 years old, born onJanuary 1, 1978. During your lifetime, the prices of all items in the CPI marketbasket have risen approximately 278 percent (an average annual rate of 3.7percent). However, when separated into categories, medical care has risen 653percent (an average annual rate of 5.6 percent), while apparel has risen only 57percent (an average annual rate of 1.3 percent) since your birth. You can likelysee how your individual market basket influences your personal inflation rate(see the figure). If you have spent a larger portion of your income on medicalcare, for which the average price has risen faster than most prices, your personalinflation rate has been higher than the CPI inflation rate. On the other hand, ifyour twin sister has spent a larger portion of her income on clothes, for whichthe average price has risen more slowly than most prices, her personal inflationrate has been lower than the CPI inflation rate.

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NOTE: As stated in the essay, the average age of individuals in the United States is 37.6 years.Assume here that the average person was born on January 1, 1978. Using FRED® to set theindex at 100 on that date, prices of all items in the CPI market basket have risen approximately278 percent (blue line). However, when separated into categories, medical care has risen 653percent (red line), while apparel has risen only 57 percent over that period (green line).

SOURCE: FRED , Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. ConsumerPrice Index for All Urban Consumers: All Items, Medical Care, Apparel;https://research.stlouisfed.org/fred2/graph/?g=1AxN(https://research.stlouisfed.org/fred2/graph/?g=1AxN).

The Everyday Price Index

The Everyday Price Index (EPI), published by the American Institute of EconomicResearch (AIER), is designed to reflect price changes for the goods and servicespeople buy frequently—at least once per month. The index uses the CPI butsimply pulls the goods and services purchased on a day­to­day basis out of theCPI basket and puts them into the EPI basket. In other words, it creates asmaller market basket that includes only these everyday goods and services.Note that the EPI is not meant to reflect total consumer spending; rather, it ismeant to reflect the “price changes felt by Americans on a day­to­day basis.”The AIER tracks and reports monthly on the inflation rate of this market basket.

The EPI focuses on purchases that consumers cannot easily postpone or forgo(such as food, fuel, and prescription drugs). Consumers must absorb thefluctuations in prices as they happen. The largest categories in the EPI basket

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(comprising nearly half) are food at home (21.5 percent), food away from home(15.1 percent), and household fuels and utilities (13.4 percent). By contrast,the BLS gives those same categories much lower weights in the CPI marketbasket: food at home (8.4 percent), food away from home (5.8 percent), andhousehold fuels and utilities (5.2 percent). Goods such as cars, appliances, andfurniture are not included in the EPI simply because they are not everydaygoods. They are purchased infrequently, or consumers can sometimes delay thepurchase of these goods. The EPI also excludes goods with prices fixed bycontract, such as mortgage and rent payments, because consumers areprotected from price increases during the contract period. This smaller marketbasket is more volatile than the much larger CPI market basket. Over the past20 years, the EPI indicates that everyday prices have risen by 76 percent (anaverage annual rate of 3.2 percent), while the CPI indicates that prices haverisen by 56 percent (an average annual rate of 2.3 percent). The EPI might behelpful in explaining the difference between the actual (lower­than­average)inflation rate and the perception by many people that prices are rising quickly.Differences in the visibility of certain prices might also impact your perception ofinflation. For more information, see the boxed insert, “Perception and ‘Visible’Prices.”

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Conclusion

The CPI is designed to reflect the purchases of the typical urban consumer, andnot all people are typical or urban. More importantly, the CPI is meant to reflectthe experience of the average household, but differences in individual consumerchoices nearly guarantee that the inflation rate experienced by any individualvaries from the average inflation rate. In addition, the prices of some goods thatare more visible might influence people’s perception of inflation because theprices are both noticeable and volatile. In short, it is good to remember thatwhen it comes to national statistics such as the CPI, actual (individual) resultsmay vary.

Notes1

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“Inflation Misses Fed’s 2% Target for 38th Straight Month.” Real Time Economics (blog), WallStreet Journal, August 3, 2015; http://blogs.wsj.com/economics/2015/08/03/inflation­misses­feds­2­target­for­38th­straight­month/ (http://blogs.wsj.com/economics/2015/08/03/inflation­misses­feds­2­target­for­38th­straight­month/).

Real disposable income per capita in the United States has increased by 221 percent since April1960 (see https://research.stlouisfed.org/fred2/graph/?g=1sPx(https://research.stlouisfed.org/fred2/graph/?g=1sPx)).

Economists prefer a small “inflation buffer” to reduce the risk of deflation. For a more detaileddiscussion of inflation in the context of price stability, see Wolla, Scott A. “Money and Inflation: AFunctional Relationship.” Federal Reserve Bank of St. Louis Page One Economics Newsletter,March 2013; https://research.stlouisfed.org/publications/page1­econ/2013/03/01/money­and­inflation­a­functional­relationship/ (https://research.stlouisfed.org/publications/page1­econ/2013/03/01/money­and­inflation­a­functional­relationship/).

Board of Governors of the Federal Reserve System. “Press Release.” January 25, 2015;http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm(http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm). Note: While theFederal Reserve considers many measures of inflation in its assessment of the economy, itsinflation objective is stated in terms of the personal consumption expenditures price index(PCEPI).

U.S. Bureau of Labor Statistics. “Consumer Price Index. FAQs: Question 6.” UpdatedSeptember 17, 2014; http://stats.bls.gov/cpi/cpifaq.htm#Question_6(http://stats.bls.gov/cpi/cpifaq.htm#Question_6).

U.S. Bureau of Labor Statistics. “Consumer Price Index. FAQs: Question 8.” UpdatedSeptember 17, 2014; http://stats.bls.gov/cpi/cpifaq.htm#Question_8(http://stats.bls.gov/cpi/cpifaq.htm#Question_8).

U.S. Bureau of Labor Statistics. “Consumer Price Index. FAQs: Question 3.” UpdatedSeptember 17, 2014; http://stats.bls.gov/cpi/cpifaq.htm#Question_3(http://stats.bls.gov/cpi/cpifaq.htm#Question_3).

The Federal Reserve Bank of Atlanta offers a CPI tool that may more accurately reflect anindividual household’s market basket. Its myCPI tool allows you to track the prices of a marketbasket more like yours and compare your CPI with the national average. Seehttps://www.frbatlanta.org/research/inflationproject/mycpi.aspx(https://www.frbatlanta.org/research/inflationproject/mycpi.aspx).

Central Intelligence Agency. The World Factbook. Updated July 15, 2015;https://www.cia.gov/library/publications/the­world­factbook/geos/us.html(https://www.cia.gov/library/publications/the­world­factbook/geos/us.html).

FRED , Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. Personal IncomePer Capita; https://research.stlouisfed.org/fred2/series/A792RC0A052NBEA(https://research.stlouisfed.org/fred2/series/A792RC0A052NBEA).

Cangero, Theodore; Delorme, Luke F. and Vlasenko, Polina. “Improving the Everyday PriceIndex.” May 16, 2014; https://www.aier.org/research/improving­everyday­price­index(https://www.aier.org/research/improving­everyday­price­index).

Cangero, Theodore. “Poultry and Eggs Lead Food Prices Higher.” July 17, 2015;https://www.aier.org/research/poultry­and­eggs­lead­food­prices­higher(https://www.aier.org/research/poultry­and­eggs­lead­food­prices­higher).

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U.S. Bureau of Labor Statistics. “Table 1 (2011­2012 Weights). Relative Importance ofComponents in the Consumer Price Indexes: U.S. City Average, December 2014.”http://stats.bls.gov/cpi/cpiri_2014.pdf (http://stats.bls.gov/cpi/cpiri_2014.pdf).

Cangero, Theodore and Delorme, Luke F. “EPI Methodology.” May 15, 2014;https://www.aier.org/research/epi­methodology (https://www.aier.org/research/epi­methodology).

GlossaryConsumer price index (CPI): A measure of the average change over time in the prices paidby urban consumers for a market basket of consumer goods and services.

Dual mandate: The Federal Reserve’s responsibility to use monetary policy to promotemaximum employment and stable prices.

Inflation: A general, sustained upward movement of prices for goods and services in aneconomy.

Inflation rate: The percentage increase in the average price level of goods and services over aperiod of time.

Market basket: A selected group of consumer goods and services whose prices are tracked forcalculating a consumer price index and measuring the cost of living.

Price stability: A low and stable rate of inflation maintained over an extended period of time.

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