Update No. 83 – 26/10/12

I have linked many times previously to Scott Sumner’s blog; he is my favourite economics blogger, an enviable thinker.  His new paper on NGDP targeting (pdf) is a breath of fresh air, particularly how it envisions dealing with bail-outs & moral hazard.He also had a post a month ago about inflation and market perceptions.  As I have mentioned in past posts, people everywhere have a very weird propensity to think things are getting worse, regardless of the overwhelming empirical evidence that global living conditions are inexorably improving. An excerpt from the post says:

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 . . .”

House prices are not part of the inflation calculation (though rents are and there is at least some correlation between these) but the statement reminds us that persons with different consumption patterns will be very differently affected by inflation, depending on how it occurs.

For example, consider someone (say a retired person) who spends say 1/3 of their income on medical expenses and 1/3 on food and the final 1/3 on ‘other’ goods that approximately track normal inflation (with no spare income for saving).  Assume (for ease of calculation) this person survives on $300 per week ($100 on medical, $100 on food & $100 on ‘other’) that is indexed to inflation.  If inflation over the year is 1.5%, their adjusted income in the next year will be $304.50.  However if the inflation rates of food & medical were 5% over the same period, in order to consume the same as last year, the person above would need to spend $311.50 per week ($105 on medical, $105 on food and $101.50 on other).  This person could indisputably argue they were worse off.  In simple terms the person above has two options – change their consumption habits to reflect the new situation (perhaps buying generic medication or somehow substituting more expensive foods with other products), the alternative is to continue with the same consumption patterns and erode their savings.  Only one of those options is sustainable long term…

The example above shows that on an individual level, it is (and always will be) very easy to find examples of people who are disproportionately affected by CPI changes – you will constantly see examples of such people on current affairs programs and in tabloid newspapers explaining how life has never been harder.  Even if you earn $26 million playing football, you can still go bankrupt if you’re spending $5,000 per week on cheesecakes!

The idea of the free-market is that people should alter their consumption habits to reflect the new information.  If medical and food expenses are large components of your outgoings and their costs are rising at faster than the rate of your income, we must find ways to mitigate.  If you’re at risk of losing your multi-million dollar job as a quarterback, a $5k per week Cheesecake shop habit will need to be likewise adjusted.

We all suffer cognitive biases, and see things through our own experiences. When we look at the CPI figures, we need to remember the figure reflects a statistical agencies ‘best guess’ of the change in prices of a basket of goods (that approximately reflects the consumption of the average household).  When looked at as a national or global group it would not be hard to argue that ‘we’ve never had it so good’, we just occasionally forget it because our last electricity bill was much higher than the one before it, or some such – Tony Hansen 26/10/12.

P.S. Our unit price fell for the first time in 8 weeks this week (though not quite as far as the broader market), the positive to draw out of that is that it came with a fall in the prices of some stocks we are keen on and we shall take the opportunity to start a bit of purchasing in the next week or two if prices stay weak in those stocks…

EGP Fund No. 1 Pty Ltd. Up by 15.97%, leading the benchmark by 4.99% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 19.44%, leading the benchmark by 20.07% all-time (April 1^st 2011).