Saturday, May 16, 2009

Explaining the Fall in CPI

The most recent Bureau of Labor Statistics’ report demonstrates that the urban consumer price index (CPI) decline 0.7% from April ‘08 to April ‘09—the biggest fall since 1995. Excluding food and energy, or commonly known as core prices, have increased 1.9%. Policymakers use core prices as a proxy to manage inflation because they perceive they do not have “control” of the excluded items. This policy approach is a distortion because food and energy prices are legitimate costs bear by all consumers. I will explain why prices have decline momentarily.

But there is a deeper issue concerning the CPI that warrants further explanation—that is, the nature of indexation. Indices in many instances, the CPI included, are inadequate indicators to value a desired activity. First, the CPI is made up of a basket of goods and services set in a particular base year—this mean that the basket does not change from year to year. The problem is that consumer preferences change over time and hence their consumption habits. Indeed, the basket of goods and services can be altered at some point; however, the CPI is far from being a real-time indicator of preferences. What matters are relative price changes, not changes in the CPI. Second, “nonmarket goods” (e.g. recycling, clean environment) are not counted as part of the CPI basket of goods. Third, each individual imputes value to goods, which in many instances will deviate from their price. As such, the CPI’s basket of goods and services is far from static in terms of individual consumption: some people will consume more or less of what this basket constitutes. Fourth, outliers easily distort averages; that is, one large data point can skew the distribution. Therefore, it is more reasonable to use the median CPI as a rough proxy.

Having said that, the primary reason the fall in the CPI has to do with a massive fall in private inventories, which declined at an annual rate of 2.79% in 1Q’09 (see table 1.1.2). In comparison, for the years of 2007 and 2008 inventories declined .40% and .26% respectively. Except for 3Q’08, private inventories have fallen each quarter of 2008 and 2009. On a greater scope, they have fallen steeply since 2006. Private inventories consist of the following:

“purchases of fixed assets (equipment, software, and structures) by private businesses that contribute to production and have a useful life of more than one year, of purchases of homes by households, and of private business investment in inventories. Inventory investment, which is shown as “change in private inventories,” includes the value of goods produced during a period but not sold, less sales of goods from inventories that were produced in previous periods” [see page 8 here].

These figures (and the St. Louis Fed chart) tell us that firms are producing less (hence the fall in capacity utilization) and are selling-off their excess inventory in greater measure. The steep fall reveal that firms built an extraordinary amount of inventories during the bubble years. The recent fall in prices merely represent the law of demand and supply at work.

The trend of the annualized median CPI over the last several months, however, demonstrates a small decline in prices, but not as extreme as reported by the urban CPI. In November 2008, the 12-month percent change was 3%, 0.4% higher than the figure reported as of April 2009.

In conclusion, prices are declining because of excess quantities supplied and inventoried over the last expansionary economic cycle. The median CPI, an imperfect yet rough proxy of consumer spending habits, continues to demonstrate price inflation.

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