Adjusting gas prices for inflation

Factual Questions
1

I keep hearing that current gasoline prices are not at their all-time peak when adjusted for inflation. Inflation is usually figured by factoring in the prices of many things, like food, fuel, housing, etc. The Consumer Price Index is calculated this way, for example. It has occurred to me that, since the cost of gasoline is a significant part of the cost of living, it might be misleading to adjust the cost of gas by using an index that includes the cost of gas.

Let me try to make this clearer: suppose there were an index of inflation for which the cost of gasoline accounted for 90% of the index’s value. If one used this index to adjust for the cost of gasoline with respect to inflation, it would look like the cost hardly fluctuated at all.

Now, I’m sure that gas doesn’t account for 90% of the CPI (or other indexes), but at the same time the cost of petroleum affects the cost of many things. Petroleum (in different forms) is used for transportation, manufacturing and materials. When the cost of crude oil goes up, the cost of almost everything goes up. So the CPI is correlated to something that also correlates to the price of gas.

So my questions are, how meaningful is it to adjust the cost of gas for inflation using conventional indexes, and is there some way to get a more meaningful adjustment?

2

You’re correct that it would be more precise to adjust the price of gas using the non-gasoline components of the CPI. But it would also be more difficult, the gain in accuracy wouldn’t be that great, and your answer still wouldn’t be exact.

According to the Bureau of Labor Statistics (pdf), gasoline accounts for 4% of the CPI. Other forms of energy (mostly electricity to power your house) account for another 4%. The price of electricity correlates highly with the price of gasoline, but not perfectly, since both include factors of production other than oil. So in calculating a “better” gasoline deflator, should we back just gas itself out of the CPI, or all forms of energy? There’s no right answer. (In addition, as you point out, energy is a factor of production for many unrelated products. The problem rapidly becomes mathematically intractable.)

But just for the sake of argument . . . we’ll back out all energy costs, but nothing else. Imagine that, in a particular year, the price of energy rises by 20%, and everything else rises by 3%. The BLS calculates the rise in the CPI as (.08 * 1.2) + (.92 * 1.03) - 1 = 4.36%.

Then we say, in real terms, the price of gas rose by 1.2/1.0436 = 15%. Whereas the real real rise, if we back energy itself out of the CPI, was 1.2/1.03 = 16.5%.

So yes, with the unadjusted figure, a certain amount of understatement is likely. But the adjusted figure of 16.5% still isn’t mathematically exact, and you’ll end up debating it all day. So most people don’t adjust.

3

I’m not a statistician, but my guess would be that how meaningful a given index is depends on your point of view. For a consumer, probably an index based on the development of wages and salaries might be more meaningful because it compares price levels based essentially on how much time you would have to work to earn the money for a given quantity of gasoline; but this index would be distorted by a variety of factors, most importantly the development of productivity.

Adjusting inflation based on consumer price indexes seems a good apporach to me because it tells you how the prices of a given commodity developed compared to the average of the commodities a usual household would normally consume. It’S true that gasoline and other petroleum-based products constitute a considerable portion of this average; but the main point, namely the price of oil products compared to the average consumption of the household, is not affected.

Also note that the composition of the basket on which the calculation of the CPI is based changes over time, reflecting changed consumption behavior.

Let me name an example.

Suppose our households consume only three types of products: Apples, widgets, and gasoline (as gasoline, I will summarize everything based on oil). Each one accounts for one third of the index.

In year 1, everything would cost $1 for a given quantity of each commodity.
In year 2, the price of apples has decreased to $0.80, widgets remained stable, but gasoline increased to $1.50.

Now it would cost you $3.30 to buy what used to cost you $3 in year 1, so the CPI gives you an adjustment rate of 10 %.

If you use this rate to adjust the prices, you’ll see that the prices were $1.10 in year 1,m expressed in year 2 dollars. So the price of gasoline rose from $1.10 to $1.50, a 36 % increase. Both of the other products decreased effectively.

Is it meaningful to say that, adjusted for inflation, gas rose by 36 %, even though the gas price itself constitutes a large portion of the index? If you interpret it as saying that gas prices increased considerably faster than the other commodities purchased by consumers, I would say yes.

4

The Bureau of Labor Statistics publishes dozens upon dozens of price indices, inluding one “All items less energy”.

5

— So my questions are, how meaningful is it to adjust the cost of gas for inflation using conventional indexes, and is there some way to get a more meaningful adjustment?

Using a conventional index you get, “The price of gas, relative to all other goods purchased by a typical urban consumer, including gasoline.”

If you took out gasoline you would get, “Relative to all other goods (consumed by our typical urban buyer)”.

In practice, there’s not too much difference, except perhaps for rents.

Dig into http://www.bls.gov/bls/inflation.htm for more price indices than you would ever want to look at.