Measuring Inflation Accurately

Abstract

The most commonly used measures of inflation suffer from persistent and well-documented biases. As a result, official price indices overstate the inflation rate. The most prominent inflation measure, the Consumer Price Index (CPI), has historically overstated inflation by about seven-tenths of a percentage point each year. The Personal Consumption Expenditures price index (PCE) overstates inflation by about four-tenths of a percentage point per year. Neither of these common price indices fully accounts for the benefits of increased competition in retail, the rapid decline in price of new products, or the improved quality of many products over time. Overstatements of inflation have led many analysts to conclude that living standards have stagnated since the 1970s. The mis-measurement makes old incomes look larger, in inflation-adjusted terms, than they really were. Accurately accounting for inflation shows that typical American incomes grew at a healthy pace until 2007. A bias-corrected price index shows that real median wages grew 30 percent between 1979 and 2007. Real middle-quintile household incomes grew around 65 percent over that period. In the generation preceding the Great Recession, living standards rose considerably. Only since 2007, in response to the Great Recession and the sluggish recovery, have Americans begun to worry about wage stagnation.

Keywords: Inflation, Price Index, CPI, PCE, Wage Stagnation

JEL Classification: E300