What Is Inflation?
Your grocery bill went up 25% since 2020. Your house doubled. The S&P 500 tripled. Yet the official inflation rate was "only" 3-8%. How can all of these be true at the same time?
The answer is that different price indices measure different things, and each embeds specific methodological choices about scope, weighting, and quality adjustment.
Consumer Price Inflation (CPI)
The Consumer Price Index tracks a basket of goods and services that a typical urban household purchases: food, rent, energy, healthcare, transportation, and so on. When economists and central bankers say "inflation," they almost always mean CPI or a closely related measure.
Key institutional facts:
- CPI-U is published monthly by the Bureau of Labor Statistics (BLS) in the United States. Eurostat publishes HICP for the euro area; Statistics South Africa publishes its own CPI.
- It measures the cost of living: the expenditure needed to maintain a constant standard of living over time.
- It deliberately excludes financial assets (stocks, bonds, direct real estate investment) by design. This is a scope choice, not an error.
Methodological choices that matter:
- Geometric mean formula: The BLS uses geometric means within item categories, which partially accounts for consumer substitution. This tends to produce lower readings than a pure Laspeyres (fixed-basket) index (Boskin et al., 1996).
- Hedonic quality adjustment: For goods like electronics and vehicles, the BLS adjusts for quality improvements, so a "better" phone at the same price registers as a price decline. Reasonable in principle; consequential in practice (Hausman, 2003).
- Owner's Equivalent Rent (OER): Rather than tracking house prices, CPI imputes housing costs for homeowners using rental survey data. OER constitutes roughly 25% of CPI-U and lags market rents by 12-18 months (Adams et al., 2022).
Asset Price Inflation
Asset price inflation refers to the sustained rise in the prices of financial assets beyond what changes in fundamentals (earnings, rents, discount rates) would justify. Unlike CPI, there is no single official "asset price inflation" index. Instead, we use valuation ratios:
- Price-to-Book (P/B): how much investors pay per dollar of balance-sheet equity. Sensitive to sector mix and intangible capital.
- Forward P/E: price divided by consensus next-twelve-months earnings. Reflects both expectations and discount rates.
- CAPE (Shiller P/E): price divided by the 10-year average of real earnings. Smooths business cycles; more useful for long-horizon return prospects than short-term timing (Campbell and Shiller, 1998).
When these ratios are historically elevated, it suggests that asset prices have risen faster than the fundamentals that support them.
Why the Divergence?
Since 2008, consumer prices and asset prices have often moved in opposite directions. CPI stayed low while equities and housing appreciated rapidly. This is not a contradiction: it reflects different channels of monetary transmission operating at different speeds (Bernanke, 2020). The next articles explore why, through the lens of money supply, central bank policy, and academic theory.
References
- Adams, B., Loewenstein, L., Montag, H., & Sojourner, A. (2022). "Do Rental Markets Moderate Shelter Inflation?" Federal Reserve Bank of Cleveland Working Paper.
- Boskin, M. J., Dulberger, E. R., Gordon, R. J., Griliches, Z., & Jorgenson, D. W. (1996). "Toward a More Accurate Measure of the Cost of Living." Final Report to the Senate Finance Committee.
- Campbell, J. Y. & Shiller, R. J. (1998). "Valuation Ratios and the Long-Run Stock Market Outlook." Journal of Portfolio Management, 24(2), 11-26.
- Hausman, J. (2003). "Sources of Bias and Solutions to Bias in the Consumer Price Index." Journal of Economic Perspectives, 17(1), 23-44.