Why do governments set their inflation rate targets at around 2%? Is inflation not a bad thing? Wouldn’t an inflation rate of zero be better? In this post, the subject of inflation and wages will be discussed. By looking at the inflation and wages growth rate since the 1970s, it seems clear that the bottom half of the male workforce in the U.S. did not do that well over the past decades. Their counterparts, however, female workers in the U.S. did see a significant pay raise. By combining the wages, however, a real increase in pay did occur.
What is inflation?
Investopedia defines inflation as:
“A quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over some period of time. It is the rise in the general level of prices where a unit of currency effectively buys less than it did in prior periods. Often expressed as a percentage, inflation thus indicates a decrease in the purchasing power of a nation’s currency.”
In contrast to deflation, which occurs when prices decline instead. In other words, inflation reflects the loss of real value per unit.
Estimation of inflation in CPI
The Consumer Price Index was created to estimate inflation. It measures the changes in the price level of a weighted average market basket of consumer goods and services purchased by households. Goods and services in the basket normally consist of different categories like food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services.
Governments all over the world use the annual percentage change to CPI as a measure for inflation and set inflation targets with the percentage change. A desirable inflation rate is around 2%. If the rate is too high, it becomes hard for businesses to plan for the future. If it is too low, or even negative, the assumption is that it would halt the economy, for people may put off spending because of the expectation that prices will fall.
Amendment to CPI measurements
The CPI measurements have seen changes over the years and have been somewhat controversial. Originally, the CPI was determined by comparing the price of a fixed basket of goods and services spanning different periods of time, or a cost of goods index (COG). However, after the changes, the CPI became more of a cost of living index (COLI), which tracks the cost to maintain a constant standard of living. This new way of measuring takes changes in the quality of goods and substitution into account. Substitution happens when consumers respond to price changes, i.e. when a product becomes more expensive, the Bureau of Labor Statistics( BLS) will take it out of the index and substitute it with a similar but cheaper product.
Critics view this methodological change from COGI to COLI as a way to manipulate the CPI and a way for the BLS to report a lower CPI.
Wages and saleries anually growth rates in the U.S.
Before the relatively mild recession during the 1969-1970 and the subsequent decision of Nixon to pull the U.S. dollar off the gold standard, wages increased by an average of 0.4% a month during the period of 1964 and 1971. After the U.S. went off the gold standard, wages increased by 0.32% on a monthly basis. Nominally, the average wage increased by 10 times, from $2.50 to $25 today.
Figure 1 Average hourly earnings of production and nonsupervisory employees
The CPI also saw a significant increase. From 30.9 in 1964 to 255 today. The CPI increased by nearly 8 times in the same period. At first glance, it might seem that the wages have outpaced inflation and which is true for the average wage.
Figure 2 CPI for all urban consumers, all items in U.S. City average.
However, when the wages get broken down it shows a different picture.
Figure 3 Median wages for 16 years and over.
The wages have increased by a little over 10% (CPI-adjusted) in 40 years’ time. Almost 40% of the working population has a median hourly wage below $15. So around 5 times the average since 1964. In other words, a big portion of the population’s wage did not outpace inflation.
Figure 4 Median wages of men in percentiles. Source: Economic Policy Institute
Going even deeper in the data shows that the bottom 40% of the male labor force saw little increase in median wage and even decreased in the 30th and 40th percentiles. On the female side, however, wages have been increasing significantly for the 30th and 40th percentile and a modest increase for the 10th and 20th percentile.
Figure 5 Median wages of Women in percentiles. Source: Economic Policy Institute
So the overall stagnation of wages among lower-income men has been balanced out by the increase in wages among the lower-income working women. Which can explain why the overall median wages have been rising.
Protect yourself from inflation
According to the EPI and BLS inflation has been moderate for some time, however, one must not forget that due to the changes in measuring CPI it is a possibility that the inflation rate is actually understated. By measuring CPI in ways of cost of living instead of the cost of goods, depending on what the BLS defines as “living standards” the goal post can be easily shifted.
One way to protect yourself from inflation is by investing in assets that appreciate in value over time. There are multiple ways of doing this, such as investing in the stock market with ETFs. A different way of hedging yourself against inflation is by putting your money with money managers, hedge funds, and asset managers.
It is also wise to diversify your assets by allocating a small portion to markets that aren’t correlated to the stock markets, like commodities, and to some end emerging markets in digital assets like Bitcoin or cryptocurrencies. By diversifying into uncorrelated markets you spread the risk of major market movements in one portion of your portfolio. For example, the year to date the return of Bitcoin is 30%, the S&P 500 -2.4%, Dow Jones is down 8%, and Nasdaq, the only in the list of traditional markets with a positive return, 20%.