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Many people tell me that the “average people” they talk to simply don’t believe inflation rates have been low over the past 4 years, despite the headline CPI rising at roughly a 1.2% rate since July 2008. There are three reasons for this cognitive fallacy:

1. Confusing rates and levels.

2. Confusing ‘cost of living’ and ‘standard of living.’

3. Assuming the term ‘inflation’ refers only to the rise in the price of things they don’t want to see get more expensive.

A poll around 1990 showed that most people thought inflation was higher than it had been 10 years earlier. Of course inflation was far lower (5% vs. 13%). But when people hear the term ‘inflation’ they think in terms of cost of living, or price level. Not 1 person in 5 knows what a derivative is. And the cost of living in 1990 was higher than in 1980. And each month the cost of living in America hits a new record, even as inflation plunges to very low levels.

If you are a teacher, ask your class the following: “Suppose the price of all goods rose by 10%, and at the same time everyone’s income also rose by 10%. Would the cost of living have actually increased?” Ninety-five percent of students will get it wrong, even at Harvard. Of course the cost of living goes up 10%. But there is no change in the standard of living, which is what confuses the students. People feel that real incomes have done poorly in recent years; nominal incomes aren’t keeping up with inflation. And they are right! But ‘inflation’ is the wrong term for that problem, it’s falling real GDP caused by low AD. Go to Japan and ask people how they’ve enjoyed the steadily falling cost of living since 1995, and I’ll bet you get a lot of blank states (mostly because the Japanese don’t speak English.)

Imagine a newly minted college grad who moves to Florida or Arizona and starts working in a medical supply company. She goes out to buy a house, and finds that the price has been slashed in half since 2006, from $280,000 to $140,000. Then she goes to the bank and finds the lowest mortgage rates in history. The monthly payments will be laughably small. Next time someone tells you that inflation is higher than the CPI, because they pay more for groceries, point out that inflation might be overstated because house prices have fallen by 35%. Then watch the look in their faces as they process the information. “But aren’t falling house prices bad . . .”

PS. I do realize there are alternative (rental equivalent) ways of looking at the housing cost issue, but I still think my example is valid, at least to some extent. There is enormous “market segmentation” between owner-occupied and rental housing.

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This entry was posted on October 04th, 2012 and is filed under Misc.. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



