Understated Inflation?

John Mauldin makes an excellent point regarding inflation perceptions in this week's Thoughts from the Frontline weekly e-letter. In short, consumers pay more attention to the items they buy more frequently and, currently, those are the items that are increasing in price the most.

[H]igh-frequency spending items like gasoline, food, education, and medical care make up 50% of the Consumer Price Index. These are items which we buy on a regular basis. And they are going up at a weighted average rate of 6.8%, a lot higher than the 4% for the CPI as a whole.

The 20% of the CPI which are low-frequency items like furniture, appliances, vehicles, and so on are actually falling at a -0.7% rate. Since OER (equivalent rent) is roughly 30% of CPI and is rising at 2.8%, even as home prices fall the overall rate is about 4%.

Our tendency to notice the price increases in more frequently purchased items more than the drop in less frequent expenditures is known as salience. What we see every day is more visible to us and is on our minds. And because the reality is that those prices are rising much faster than headline inflation, we tend to think inflation is understated.

A thought on probability

I was at my in-laws yesterday and my father-in-law and I were watching some football. As the games were winding down, some channel surfing landed us on the movie, "Once Upon a Crime."

There's a scene where Marilyn Schwary (Cybill Shepherd) is playing roulette. She places her bet on 13 - and wins - on her first spin. On her next spin, she again places her entire bet (including her winnings from the previous spin) on 13.

My father-in-law asked, rhetorically, "what are the chances it will be 13 twice in a row?" I knew what he meant, but it got me thinking... The chances 13 would come up twice in a row is exactly the same as any other two numbers coming in sequence. The probability of that specific sequence occurring may be small, but low-probability events occur frequently.

What lowers the probability in this case is specification. To restate my father-in-law's question including the specification he probably intended, "what are the chances she will bet on 13 - and win - twice in a row?" That dramatically lowers the probability of the event occurring. In fact, if she were to bet on 13 and win 3-4 times in a row, everyone would start to be incredibly suspicious the game was rigged.

She wouldn't even have to bet on 13 each time. The specific sequence of numbers does not matter, since each sequence of 3-4 numbers has equal probability of occurring. What matters is that she correctly chooses the sequence of numbers ex ante.