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Let’s Talk About Inflation

Posted January 26, 2022 by Denis Smirnov

Couple of weeks ago December 2021 inflation number came in at a very high 7% and it generated a lot of shocking headlines. Here is a good example of the many articles published that day “U.S. Inflation Hits 39-Year High of 7%, Sets Stage for Fed Hike”. I wanted to take a closer look at the inflation components and see what’s driving it.

The headline number that gets reported by BLS is the Consumer Price Index (CPI). It’s helpful to know how CPI is calculated. Basically  the Bureau of Labor Statistics (BLS):

1) Surveys several thousand Americans every few years to come up with the weights of various items for the average consumer’s spending patterns

2) Then every month they call/visit many establishment in various parts of the country to estimate prices for 200+ goods and services

3) These prices then get adjusted by the basket weight from item 1 to estimate overall inflation

There are a lot of conspiracy theories out there about the accuracy of this method and whether the government purposefully reports low inflation numbers to keep people from revolting. Personally, I don’t think there is any big conspiracy, but rather the process is very complex and rife with statistical issues that make the resulting number hard to interpret for each individual household. Let’s take at December 2021 CPI to explain what I mean. The full and very detailed report is available here – it’s quite fascinating to dig around and marvel at some of the eye-popping price increases. Exhibit 1 show some examples: gas up 50%, used cars 37%, hotels 24%, steak and bacon 19%, although fresh vegetables only 2%!

Exhibit 1 – 2021 Inflation for Selected Items

More comprehensive but still simplified view is shown in Exhibit 2. BLS breaks things into 3 big categories: Food, Energy and Everything Else. As an example, Food accounts for 14% of average consumer’s monthly spending. It has gone up by 6.3% in 2021 and accounted for 0.886% of the 7% headline inflation number. Energy accounts for only 7.5% of the average expenditure but has gone up by 29%, thus resulting in an outsized 1.8% contribution to total price increase. I highlighted the top % price increases and contributors in each category in green.

One notable category is “Shelter”, which accounts for 32% of spending. It’s a very difficult number to calculate and can be very misleading. If you rent an apartment with an annual lease, you might get hit by a big increase. If you own a house (outright or with a fixed rate mortgage), your “rent” expense hasn’t increased at all. In fact, you are way further ahead as the value of your home asset went up by 10-15% (more on that next week). If you went from renting to buying a house, your shelter inflation was that 15% (which then gets spread out over the life of your home ownership). You see how this gets murky real quick depending on your individual situation?

So my point is that you should take the headline inflation number with a grain of salt and attempt to adjust it to your own life. If you are a gas guzzler-driving renter with six kids who eats bacon-wrapped steak at every meal, is allergic to vegetables, often stays at hotels and buys another used truck every 6 months, you are screwed. If you are a 65-year old electric car-driving vegetarian homeowner, you are sitting pretty.

Exhibit 2 – 2021 Inflation By Expenditure Category

 

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