‘Tis the season for headlines about the prices of some very specific items, such as a 16-pound turkey (down from last year) or a Christmas tree (up). None of these prices, however, is a good barometer of the overall cost of living.
Even when prices rise on average more rapidly than usual, as they did in 2022, some prices rise more than others. And even in that high inflationary year, the prices of some things — such as smartphones and beef — plummeted.
Focusing on individual prices can fuel arguments about the state of the economy. But not every price change is a sign of inflation. Economists distinguish between relative price changes, which contain a lot of important information, and a rise in the overall price level. Relative price changes reflect the ebbs and flows in supply and demand of specific goods. An increase in the overall price level is inflation.
Inflation can affect the price of a Christmas tree in the same way it affects the price of all goods, services and incomes. But the price of a Christmas tree can also go up because of a change in supply due to climate or technological changes, or because consumer demand changes.
It is useful to pay attention to how much individual prices are changing — not because of what it says about inflation, but because the information can guide the choices of both consumers and producers.
If the price of live Christmas trees is rising because demand is increasing, the higher price sends a message to potential sellers that they should consider planting more trees. Increasing prices also send a message to buyers: Perhaps it’s time to switch to an artificial tree. (Or, if you’re one of the millions of US homes with more than one tree, you might consider cutting back to just one.) The point is, buyers and sellers adjust their behavior in a way that eventually brings the market into equilibrium.
Inflation is something different: It is a rise in the cost of living because, on average, the same stuff today costs more than it did the year before. There are some ways to protect yourself from inflation — spend more time looking for cheaper versions of the same item, or shop around for higher interest rates on your savings and checking accounts. Inflation tends to lead to greater dispersion across sellers, which increases the benefits of shopping around, since some sellers are slow to update their prices.
These tactics differ from ones you might use for relative price changes. One of the challenges of inflation is that it makes it harder for people to distinguish between relative price changes and the rising tide that is lifting all prices.
While the distinction between inflation and relative price changes is sharp in theory, the reality is a little messy. How do we measure the cost of living when the cost of living is a function of what we choose to buy, which is itself a function of the relative prices of various goods?
By way of illustration, consider the PNC Christmas Price Index, which lists the price of each gift in the song “The 12 Days of Christmas.” This year if you wanted to give your true love all 12 presents, you’d need $46,729.86, a 2.7% increase from last year. That is slightly less than the overall rate of inflation measured by the federal government’s consumer price index. So if you spend most of your money on the 12 days of Christmas, you’re in luck! But like any inflation index, the prices of some items went up by more than others. On the first day of Christmas this year, you’ll pay 13.9% more for a partridge in a pear tree, while the price of two turtle doves soared 25%. But you won’t pay any more for four calling birds or five golden rings.
That different people actually have different baskets is not the only reason the CPI is not a perfect measure of inflation. In fact, economists think that the CPI might overstate inflation by roughly a percentage point for three reasons: new, better goods that replace items in the basket; quality improvements in existing items in the basket; and consumer efforts to maintain their quality of life as some prices rise more than others.
This is why the right way to measure inflation is the subject of research papers, conferences and differences of policy opinion. There have been controversial policy debates about whether to use a “chain-weighted CPI” — which takes into account how people switch among goods and services as the prices of some things increase more than others. And the evidence that CPI overstates inflation is one reason the economy works better if there is a little bit of measured inflation.
So if you want to know what’s happening with your own inflation, look at what you spend your money on and compare it to the Bureau of Labor Statistics’ measures of inflation in those categories. If you see a price that is particularly high, you might want to consider buying something else or shopping around. And the next time you see a headline or meme claiming that the price of a single item shows how terrible inflation is, realize that this is a terrible way to think about inflation.
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