Damned Replacements

Headline inflation is an item about which many central bankers and investors appear to fret these days. But the headline inflation is only a number. It is an artificial figure. For example, from it the cost of energy and food is stripped out. “Because they are volatile, up one month down the next”, say the inflator-deflator folk (responsible calculating inflation); but this should go to undermine their credibility since rather persistently food and energy have been up and up of late, with precious little down. The inflation deflator, as it now stands, does not reflect that pain to the pocket.

A more worrisome idea is that of “replacement” which was incorporated into inflation calculations. This seemed like a good idea at first: why compare prices of the same item in the same department stores from month to month when into the neighborhood comes a Walmart with radically lower everyday low prices on a private-brand product replacing the one whose price we wish to measure. (Cheapy beans vs brand name beans, say). But there is a danger here, for one could easily take this too far, by saying for example “why compare the price of lemons this and last month when this month we have a new lemon juice extract, as healthy and as useful in cooking, one bottle being the equivalent of 7 fresh lemons, which makes it, on a per lemon basis, much cheaper”? And further: one could say, yes these Florsheim shoes are up 10% this month, but one could buy flips flops instead, which are in fact much cheaper than the Florsheims, and thus by their cheapness reduce the notional cost of Florsheim shoes (which no one is obligated to buy) and thereby – inflation.

More worrisome is another aspect of replacement: when a whole segment of a market, usually the bottom, disappears. In early 90’s the whole segment of cheap shoes – shoes for under $20 dollars – seemed to disappear in the US. Merchants no doubt preferred to sell the expensive sort and didn’t feel much incentive to carry the cheap; and consumers were rich enough by and large to go happily with the expensive sort; so the cheap shoes just disappeared. The disappearance of the cheap segment of the market did not therefore seem to happen by violence or manipulation, but it did happen. Yet, I do not think this was reflected in the inflation deflator figures: no one in the inflation calculation department seemed to have said: “wait a minute, the cheap shoes have been replaced with the expensive ones! Let’s calculate that!” The same seemed to happen with eyeglass frames after the establishment of Luxotica as a major market leader. It is still possible to buy reading glasses in the US in cheap frames – for under $10 a pair, which proves that cheap glass frames can be made and distributed; but such cheap frames for normal prescription glasses have disappeared from optical shops. In both cases, the resulting pain to the consumer was huge – a matter of several hundred percent in price increases – but not reflected in inflation calculations at all.

And what about cars? Cars cost now nearly double what they cost a decade ago. This has in part to do with such phenomena as the increasing size of the average vehicle – a market phenomenon perhaps comparable to what happened in the shoe market; but also in part with the government mandated air-bag which added $1,200 to the price of an average car. The option to buy a no frills car without an air bag has been closed, and that segment of the market eliminated forever.

These changes make our life more expensive. They do so by stealth and they are not reflected in the inflation deflator. But they hit us in the pocket; and hit us in the pocket more than then 2% rise in the cost of toothpaste recorded in 2007. Don’t be lulled by the inflation figures put out by the central bank.