Three Reasons Inflation Isn’t What You Think

BlackRock explains why people tend to perceive inflation as greater than it actually is, and why this matters for portfolios.

Though U.S. inflation has been firming recently—the core consumer price index (CPI) rose in April for a third month in a row—prices likely aren’t rising as much as you may believe.

Why? It turns out that people commonly perceive inflation as greater than it actually is. In a telephone survey conducted in the late 1990s and early 2000s, researchers from the Federal Reserve Bank of Cleveland asked 20,000 participants to state at what rate they thought prices had risen over the previous 12 months. Inflation as measured by the CPI during the period of the study was 2.7 percent, yet respondents thought it was roughly 6 percent.

The gap between inflation perception and reality can have significant implications for one’s purchasing decisions, and for investing as well.

There are many reasons why this gap exists. Today, many people are concerned about a future uptick in inflation thanks to the Federal Reserve (Fed)’s monetary stimulus, and we also live in an age of mistrust of public institutions, where people tend not to believe the official numbers. In addition, there are three other key reasons why inflation may not be what you think.

You may have your own basket of goods

The CPI, produced on a monthly basis by the Bureau of Labor Statistics, aims to track the price of a basket of goods and services purchased by urban consumers. While the CPI was originally produced as a cost of goods index, over time it has increasingly become a cost of living index. Examples of the prices it tracks include the prices of food, shelter, utilities, clothing, medical care, cars, transportation and gasoline.

The personal consumption expenditure (PCE) measure, another inflation metric, differs from the CPI in its scope and weighting of consumption items. Notably, the PCE, the Fed’s preferred inflation measure, reflects not just consumers’ out-of-pocket expenses but also purchases made on their behalf, such as medical premium payments by employers.

Just as the basket of prices tracked differs depending on the inflation measure, the consumption basket that applies to each individual may vary from the official ones, particularly with regards to how much is spent on each consumption item.

You may overweight certain purchases

People tend to overemphasize purchases that are frequent, even if small, and purchases whose prices are volatile (think gas purchases, for instance). As a result, gas prices may actually impact a consumer’s inflation perceptions more than the purchase of a car. Similarly, the more recent a purchase, the more people incorporate it into their inflation assessments, even if it’s just a small, and as such less important, component of one’s overall consumption basket.

Personal experiences also matter: In forming inflation assessments, people tend to overweight prices from their personal experience at the expense of all available historical data. As such, following the high inflation years of the 1970s and 1980s, young people expected much higher inflation than older people, as the younger generation’s experience was dominated by more recent observations.

You may be making calculation errors of sorts 

People may also not fully account for quality and technological improvements, for example increases in computer processing power, in their assessments, feeling prices are going up disproportionately. Similarly, people tend to notice when prices are increasing but may ignore a trend of decreasing prices (for instance, electronics are a lot cheaper today than 15 to 20 years ago). This is similar to loss aversion in investing, where losses are felt more poignantly than similar size gains.

In addition, individuals may disproportionately attribute lower prices to their own skill at finding bargains and attribute higher prices to inflation, another symptom of the human tendency toward overconfidence. Finally, while taxes aren’t part of the consumption basket, people often feel income tax increases as inflation. In the same vein, consumers often mentally bundle together the cost of housing, which is part of the cost of living, along with housing-related costs like mortgage and tax costs, which are part of an investment in housing rather than cost of shelter.

To be sure, the extent of the upward bias can vary. According to the Federal Reserve Bank of Cleveland research mentioned above, people with high incomes estimated lower levels of inflation than those with low incomes, and there were similar estimation differences between married people vs. singles, whites vs. nonwhites, middle-aged people vs. young people, and perhaps most strikingly, men vs. women, controlling for other factors. While men on average estimated inflation at 4.6 percent, women thought it was 6.9 percent; curiously this gap wasn’t explained by differences in the items purchased or ignorance of the CPI.

There are a range of potential reasons for these discrepancies, but suffice it to say, they reinforce the notion that perceptions of inflation often don’t match the truth, and one’s personal experiences can help explain this.

Media stories about inflation can help correct biased inflation perceptions. This is good news, since perceiving inflation as greater than it actually is has real implications for investing.

For example, all else equal, the higher an individual’s assessment of inflation, the lower may be his or her assessment of real yields. Such inflation hawks are more inclined to borrow rather than invest at nominally fixed long-term rates. Their portfolios may also suffer from excessive exposure to investments that may not be optimal for the prevailing economic environment, including inflation hedges such as Treasury Inflation Protected Securities (TIPS); real assets such as real estate; and commodities like gold.

Sources: Linked to throughout post

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2015 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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