What Is Covid Costing You?
The Federal Reserve (Fed) recently reaffirmed that interest rates would remain near 0% until inflation increased above its 2% target, meaning that low savings rates for traditional retail savings accounts will continue to persist into the future. We’ve previously covered the importance of beating inflation and how negative real interest rates can hurt savers. According to a study by Dr. Alberto Cavallo of the Harvard Business School, Covid-19 may actually be exacerbating this problem, as changes in spending behavior have led to higher than expected inflation.
“What is the cost, at this month’s market prices, of achieving the standard of living actually attained in the base period?”
- The overarching question which the Consumer Price Index attempts to answer, BLS Handbook, Chapter 17
As a refresher, inflation is measured by the U.S. Bureau of Labor Statistics (BLS) using the Consumer Price Index (CPI). The CPI compares price changes in a fixed basket of goods and services from one period to the next. This basket includes expenses in eight categories: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. Each category is weighted according to consumer expenditures, to create item indices, and then is averaged across indexed geographies.
The CPI is limited because weights are only updated once per year and use lagged expenditure data. For example, BLS updated the CPI weights in December 2019 using expenditure information collected back in 2017–2018. One only needs to consider how their personal spending behaviors have changed over the last six to nine months to sense that the CPI, a significant factor in the Fed economic policy decisions, might not be accurately representing changes in purchasing power experienced by the typical American if they’re using two-year-old data.
Dr. Cavallo, an associate professor at Harvard Business School, set out to study the impact these changes in expenditure patterns are having on the measurement of the CPI. He started by looking at data from credit and debit card transactions, available via Opportunity Insights (OI), and mapped them back to the CPI categories. Taking the latest official weights of the CPI, he then multiplied them by the average percentage change in the corresponding expenditure category each month found in the OI data, to receive updated category weights. Finally, to take into account that total expenditures were falling over the time periods sampled, he re-computed the weights as a share of the total.
Dr. Cavallo found that while the official CPI has fallen during the pandemic, even dipping into deflation territory when measured monthly, that the updated Covid CPI did not fall quite as significantly, with the Covid impact on annual inflation growing through May 2020.
When looking at April 2020, the month when the difference between the CPI and the Covid CPI was the largest, the reason behind this behavior becomes more apparent: the general trend is that expenditures have increased in categories where inflation is positive, and have decreased in categories where inflation is negative. The category “Food at Home” is a prime example. During April 2020, when much of the country was closed or limited, people were eating at home much more often as reflected in the CPI vs Covid CPI weights. But they were also paying 2.67% more for the same goods as they were the previous month. The “Transportation” category, as you would expect, saw the opposite: decreased inflation and decreased weight.
Now, I’m no PhD, but here are a few things that might make me feel more confident about the findings in this study:
- A larger sample size. The initial study was performed in June and updated in October.
- An expanded dataset. Only credit and debit card transactions were included in this data, and while those two combine to be greater than 50% of all consumer payments, consumers do spend on categories using other methods like cash, check, and ACH payments, which are not represented.
- Peer review. Replicated results using another method by someone unrelated.
“Inflation is taxation without legislation.”
- Milton Freidman
So what does this mean for you? The Fed is tracking and responding to inflation based on the non-Covid CPI. Without an adjustment to the official CPI, the Fed is likely to lag behind in increasing their interest rates while you experience higher than expected inflation, which has a real, measurable impact on your savings. This cost comes out to be about 0.5% as of October 2020, or about the same amount that a traditional ‘high yield’ savings account pays you annually.
Matt Hamilton is Co-Founder, COO & CTO of Linus. Thanks to Matthew Nemer and Eduardo Rosas for their contributions to this post.
Cavallo, Alberto. “Inflation with Covid Consumption Baskets.” (pdf) NBER Working Paper Series, №27352, June 2020. (Revised October 2020. Harvard Business School Working Paper, №20–124, May 2020)
The report can be found here and here.
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