Inflation down, prices up?

October 2024 Mid-month bonus

Behavioral New World

October 15, 2024—Mid-month bonus

Inflation down, prices up?

A lament that reflects a common confusion: “Inflation has come way down, but prices are still high.” The statement reflects a fundamental misunderstanding. Let’s start with some basics.

The best-known price index in the United States is the Consumer Price Index (CPI), which reports the cost of a bundle of goods and services. It is intended to give an overall, broad-brush view of the cost of living. It will not perfectly reflect your personal cost of living (see Chapter 2 in my book The Foolish Corner (link)) but is a good first approximation.

Example: The CPI at the end of 2020 was 261.56; by the end of 2021, it was 280.89. Not news to anyone—we all knew that prices rose over that period.

Inflation is defined as the percentage change in the price index. Using the CPI numbers above, the annual inflation rate for the year 2021 was 7.39%, calculated as (280.89 – 261.56) / 261.56.

The causes of inflation are many and varied. There is disagreement among economists about what drives inflation.

If the inflation rate were less than 7.39% in 2022 (the following year) but still positive, there is disinflation. That is, the inflation rate has become lower over time (comparing 2022 to 2021) but remains positive. That’s the situation as of this writing—disinflation.

If prices were to fall, inflation would be negative. This event, rare in U.S. economic history, is called deflation.

Why do people mistake lower inflation for lower price levels? It involves confusing the level of prices with the changes in the level of prices. I think it is also influenced by anchoring (link). People remember prices in the pre-Covid period (say, 2019) and those prices are a reference point (anchor) stuck in their heads. Because inflation is almost always positive, today’s prices are higher than past prices despite the inflation rate coming down. Low inflation might not catch our attention, but the higher inflation rates during Covid certainly did.

To repeat the key takeaway: Falling inflation doesn't mean prices are coming down! Although some individual items might fall in price, overall prices go up when inflation is positive.

That said, knowing the rate at which prices have gone up is valuable information. Inflation means that each dollar buys less over time. If you get a 4% raise during a year of 5% inflation, your purchasing power has declined. Don’t misinterpret the 4% increase as getting ahead—you are worse off (but better off than if you got a 2% raise, of course). Being misled by the 4% increase is a form of money illusion, also discussed in Chapter 2 of my book.

Bonus fact (not-so-fun but important): The Rule of 72 applies to inflation. Take the inflation rate and divide it into 72 to get the time (in years) it will take for inflation to erode one-half of your purchasing power. Example: 3% inflation into 72 equals 24 years. That might sound like a long time but keep in mind that 3% is not an unusually high inflation rate. And:

Many people will be retired for 24 years or more. They will see their purchasing power decline by roughly half over the course of their retirement. And many people will work for 48 years or more. If there is 3% yearly inflation, their dollars will have only about 25% of the purchasing power at the end of their work life compared to the beginning.[1] Yikes!

---

[1] Purchasing power cut in half over the first 24 years, then cut in half again during the second 24 years.