Are Prices Declining?

Many people read the monthly inflation or price change announcements with detached curiosity but for many, such as social security recipients or people with contracts with built in price escalators, the price changes have a real world income impact. The price change announced in August 2009 reported a 2.1% decline over the preceding 12 months. Sounds like good news since this indicates that we are paying less for what we buy compared to what we paid 12 months earlier. However, the reported price change did not match my experience and, I expect, doesn't match the experience of most people. I was notified in 6/09 that my medical insurance premiums were increasing by 14.4%, notified in 8/09 that my annual property taxes were increasing by 10.8%, my condo fees have increased by more that 10% over the last year and I haven't noticed any price reductions in the grocery store. For those of you interested in why the CPI probably doesn't match your experience, following is a brief explanation of why this might be the case.

The monthly price changes are calculated by the Bureau of Labor Statistics (BLS) which is part of the Federal Department of Labor. The headline inflation rate reported by the BLS is typically the CPI/U which is the consumer price index for urban areas and covers approximately 87% of all consumers. Following are some of the reasons why the CPI reported price changes might not reflect the experience of every consumer.

1. The costs of buying and maintaining an owner occupied home is not included directly in the CPI. Rather, the BLS uses a concept called Owner's Equivalent Rent to indicate home ownership related costs. Essentially, BLS measures monthly rent for rental housing and assumes that the owner of the rental unit calculates rental rates to fully reflect all costs such as mortgage interest, taxes, insurance, etc. The assumption is that changes in rental rates will reflect the changes in the costs which are also experienced by home owners. However, over the last several years, with the housing bubble rapidly first inflating and then deflating which resulted in a significant over supply of rental units, rental unit owners priced rents for what the market would pay rather than to fully reflect their costs. Rental rates have been declining in most if not all markets which misrepresents the increasing costs experienced by most home owning consumers. For example, the CPI/U in July 2009 shows an annual price decline of 0.7%. However, if you live in your own home, especially if you have no mortgage or a fixed rate mortgage, I expect that your costs have not declined and may have increased significantly.
   
2. The costs of medical care are measured based on the payments made to medical care providers such as doctors and hospitals and do not measure health insurance premiums. So, by example, if Blue Cross aggressively negotiates rates with providers and reduces payment to the providers but still raises the premiums charged to the insured, the CPI will show a decline in medical care costs even though you are paying more in premiums. BLS also measures health care insurers charges included in insurance premiums for reserves and profit but for some reason these studies are not published. The CPI/U for medical care in July 2009 shows an annual price increased of 3.2% which is much less than most health insurance premium increases.
   
3. BLS staff collect price data for a basket of goods which includes almost everything that anyone might buy from pet food to TV's to medical care but most people will not buy everything in the basket of goods. For instance, many people who live in New York City don't own cars so changes in gasoline prices don't directly apply to them.
4. BLS calculates a weight for each item in the basket of goods which represents the percent of total income spent on the indicated category by the typical consumer. For instance, home ownership and medical care represent 24.3% and 6.4% of the basket of goods. Consequently, an item with a large weight which has even a small price change can have a large impact on the CPI.
5. BLS adjusts prices for an item to reflect changes in quality or function. Consequently, if an item doubles in price but also doubles in quality or function then the price will be included in the CPI as unchanged. As an example, TV prices in the CPI/U show declines of 24.0%, 17.4% and 3.3% in 2007 compared to 2006, 2008 compared to 2007 and the 12 months to July 2009 compared to the previous 12 months, respectively. We all know that due to the digital transition, we paid almost twice as much for an LCD TV with a digital tuner compared to the older tube TV's with an analog tuner since but the BLS calculated a significant improvement in quality and/or function the BLS price data shows a decline in price.

Consequently, even though the July 2009 CPI shows a 0.2% price decline, if you live in New York City in an owner occupied co-op, have a fixed rate or no mortgage, don't have a car and have an individual medical insurance policy, I'll bet that you have seen your costs increase much more than the 0.2% decline reported by the BLS.

The CPI should be used to indicate price trends in general and it should be realized that the actual CPI will not accurately reflect the experience of any individual consumer. It is incredibly difficult to accurately measure prices and assign a dollar benefit to product quality which, I believe, should be reflected in the CPI. It also should be noted that a major benefit of the BLS data is to indicate changes in prices over time. Even if a better way was developed to measure prices, in order for this new price measurement to be of value, the data for previous years would need to be modified to reflect the new method in order to enable comparisons and doing this may be impossible.