Using data from the Bureau of Labor Statistics for the Consumer Price Index (CPI), students explore the latest release for January 2015, analyze the extent to which consumer misperception about the inflation rate can exist, and explore the consequences of this misperception.

KEY CONCEPTS

Consumer Price Index (CPI), Inflation, Macroeconomic Indicators, Price Level

STUDENTS WILL

  • Analyze the most current report from the Bureau of Labor Statistics with respect to the Consumer Price Index and its components.
  • Discuss reasons why the consumer perceptions of the price level can be different than reality
  • Analyze the effects of a mismatch between the real and perceived price level.

Current Key Economic Indicators

as of April 4, 2015

Inflation

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.2% in February on a seasonally adjusted basis. Over the last 12 months, the all-items price index was unchanged. The energy index increased after several months of decline. Core inflation rose 0.2% in February, the same increase as in January.

Employment and Unemployment

The unemployment rate stayed at 5.5% in March, 2015, according to the latest release from the Bureau of Labor Statistics on April 3, 2015. The number of jobs added was much lower than in previous months, with only 126,000 new jobs added to the economy, the fewest number since December of 2013. Some job categories added workers, including health care, professional and business services, financial services, and retail. Average hourly wage growth was 7 cents, but average hours worked fell.

Real GDP

Real GDP increased 2.2% in the fourth quarter of 2014, according to the final estimate released by the Bureau of Economic Analysis. This estimate is consistent with the revised estimate. In the third quarter, real GDP increased 5.0%. Consumer spending rose 4.4%, compared to 3.2% in the third quarter. Business investment and exports also increased. Offsetting these gains were increases in imports and decreases in federal government spending, particularly defense spending. (

Federal Reserve

In its March 18, 2015, statement, the FOMC cited the continued growth of the labor market, increased household and business spending, and below-target inflation as indicators of an economy that continues to recover. They expect below-target inflation to rise as oil prices increase in the medium term. The statement reaffirmed the FOMC intention to keep the federal funds rate at its current low level, but also said that a rate hike was highly unlikely at its April meeting. Notably, the FOMC dropped the word "patient" from its language describing its stance on an improving economy and a rate hike. The Fed revised downward its economic projections, including the rate of unemployment that would sustain a stable inflation rate.

INTRODUCTION

Every month, the Bureau of Labor Statistics releases the "Consumer Price Index Summary", a comprehensive report on the CPI and inflation rate. Each report provides the current estimates of price level changes for various categories of goods and services, as well as for major metropolitan areas.

This lesson uses the February 26, 2015, release for January 2015, to explore the relative changes by category, examining how consumers can form erroneous perceptions of the true inflation rate, and analyze how these misperceptions can affect the economy.

RESOURCES

  • BLS Feature: Focus on Prices and Spending- What Does the Producer Price Index Measure? The BLS breaks down the official definition of the Producer Price Index to clear up common misconceptions about prices, production, and price pass-though within the PPI.
    www.bls.gov/ppi/
     
  • BLS, Frequently Asked Questions webpage
    Frequently Asked Questions

Key Economic Indicators

as of March 7, 2015

Inflation

The Consumer Price Index for All Urban Consumers (CPI-U) declined 0.7% in January on a seasonally adjusted basis. Over the last 12 months, the all-items price index fell 0.1%, the first 12-month negative change since the period ending October 2009. The gasoline index fell 18.7% and was the main cause of the decrease in the seasonally adjusted all items index. Core inflation rose 0.2% in January.

Employment and Unemployment

The unemployment rate fell to 5.5% in February of 2015, according to the Bureau of Labor Statistics release of March 6, 2015. Total nonfarm employment rose by 295,000. Job gains were particularly strong in food services and drinking places, professional and business services, and construction. Manufacturing employment also increased, although not as much as last month.

Real GDP

Real GDP increased 2.2% in the fourth quarter of 2014, according to the revised estimate released by the Bureau of Economic Analysis. This estimate is 0.4 percentage points less than the advance estimate. Consumer spending rose 4.2%, along with business investment, exports, and state and local government spending. Offsetting these gains were increases in imports and decreases in federal government spending.

Federal Reserve

In its January 28, 2015, statement, the FOMC cited the continued growth of the labor market, increased household and business spending, and below-target inflation as indicators of an economy that continues to recover. They expect below-target inflation to rise as oil prices and other "transitory" effects diminish. The statement reaffirmed the FOMC intention to keep the federal funds rate at its current low level. Notably, the FOMC added international variables to its list of factors to monitor for the timing of a rate increase.

PROCESS

  1. Refer students to the latest Bureau of Labor Statistics report on inflation for January 2015 .

    Ask students what the change in the CPI was for the month of January 2015 [it decreased 0.7%]. What was the main cause of this change? [gasoline prices fell significantly, as did fuel oil]. What was the 12-month change? [0.1% decrease] What was the change in the core (less food and energy) inflation rate for January 2015? For the previous 12 months? [0.2% increase in Jan., 1.6% increase for previous 12 months.] 

    For the 12 month period ending in January 2015, how much did the gas index fall? [35.4%]
     
  2. Prepare a sheet of paper for each student. Half of the sheets should say, "How old was Mahatma Ghandi when he died? Was he older or younger than 9 years old?" The other half of the sheets should say, "How old was Mahatma Ghandi when he died? Was he older or younger than 140 years old?"

    Give a sheet of paper to each student. Tell them to read the questions, then write down the actual age they think Ghandi was when he died. Collect the papers, separate them into two piles according to the question asked and compute a separate average for each [it will probably be the case that those whose prompt was 9 years old will have a lower average guess of his actual age at death than those whose prompt was 140 years old. His actual age at death was 87. Even if your class does not demonstrate this difference in average guess, you can report that while this class was unusual, it is typically the case that those presented with the lower reference of 9 guess, on average, that he was 50 years old; the average for those presented with 140 is 67 years old]. Tell students that what they have just experienced (or if it didn't work in your class, what most experience) is an example of "anchoring". Anchoring is when we use a reference number to form our opinions and ideas about things. So those who saw the "9 years old" tend to guess a lower age than those who saw the "140 years old".

    Point out that we use anchors all the time in our day-to-day lives.

    New car sticker prices are so high because then consumers feel like they've gotten a good deal when they negotiated the price down a few thousand dollars--the buyer's anchor or reference point is that original price.

    When teenagers battle with their parents over what their curfew should be, the parents' anchor is what their curfew was when they were young; the teenagers' anchor is what their friends' curfew is.

    Consumers tend to buy more when something is priced at "4 for $2.00" rather than "$0.50 each"--they anchor on the number 4, making it feel like that's the better deal.
     
  3. Ask students to recall the CPI report for January 2015--the overall index fell for the month and decreased for the 12 month period, driven mostly by a fall in gasoline prices. Remind them that the gasoline index fell 35.4% over the previous 12 month period. Also remind them that the core inflation rate (absent food and energy) increased.

    Ask students what percentage of households' budgets they think is spent on gasoline. [answers will vary, but will probably be higher than the actual percentage--5%]. Tell them what the actual percentage is and ask why they thought it was higher than that [answers will vary, but steer them toward the notion that unlike almost all other consumer goods, we see the price of gasoline displayed every day, so are very sensitive to changes in its price, making it seem like a larger part of our consumption than it really is].
     
  4. Tell students that, in general, people tend to form ideas about the inflation rate from the prices of the things they buy frequently (called frequency bias). So food and gasoline prices are likely to influence people's ideas about the overall inflation rate. Ask students what they think consumers' perceptions of inflation were likely to be over the past few months [answers will vary, but they will probably say that most people would say inflation has decreased].

    Ask students if they think that perception is correct (overall inflation has decreased, but it's because of the big drop in gasoline prices--other prices have increased). Tell students that people are using gasoline prices as an anchor for their ideas about other prices.
     
  5. Ask students what they think consumers' reactions will be when gasoline prices begin to rise; i.e., what conclusions will they likely draw about the inflation rate [they should recognize that consumers will likely overreact to rising gas prices, misperceiving that inflation is increasing more than it really is].

    (Note: you can tell students about a study that asked consumers what the inflation rate for the previous 12 months had been. The average response was 6%; the actual inflation rate had been 2.9%. The reason for this misperception was that the prices of durable goods went up more slowly than the prices of non-durable goods. But because people buy non-durable goods more frequently, they took the rising prices of these goods as a sign that overall inflation had increased more than it had.)
     
  6. Ask students what problems could arise from consumers' misperceptions about the true inflation rate (help steer them toward consumers feeling: the overall health of the economy is not as good as it really is; the economy is not being managed as well as it could be; that their wage increases are not adequate to cover inflation, etc.).

    Make the closing point that it is in times like this, when the core inflation rate and the overall inflation rate are demonstrating opposite trends, that the mismatch between actual and perceived inflation can be the most disruptive to forming accurate consumer expectations.

ASSESSMENT ACTIVITY

CONCLUSION

Often consumers' perceptions of the price level and inflation are inaccurate because of anchoring and frequency bias. When core inflation and the overall CPI sharply diverge, consumers may come to the conclusion that government officials are not effectively managing inflation, or they could make investment decisions based on their erroneous conclusions about the true inflation rate. For example, when gasoline prices begin to rise, consumers will likely put a disproportionate weight on this price increase, forming conclusions about the overall price level that may be incorrect.

EXTENSION ACTIVITY

Ask students what would happen if consumers' expectations were that inflation was going to start increasing in the near future (consumers would start buying more goods and services now, when the prices are lower). Ask what effect this surge in buying would have on the economy (it would cause the price level to go up--the very outcome that consumers were trying to avoid by buying now). Make the point that sometimes macroeconomic outcomes are caused or at least intensified by changes in expectations, so that the expectations become self-fulfilling prophesies. For example, when economic agents fear that a recession is imminent, they cut back on expenditures, which further decreases GDP. 

EDUCATOR REVIEWS