The Inflated Price of my Burrito

Inflation - CPI Calculation - Governments Incentives - Money Printing

Hello, I am Nicolas Bustamante. I’m an entrepreneur and I write about long-term company building.

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This is a story about inflation. Now and then, I go to the Taqueria and order a delicious burrito. A few weeks ago, I noticed the price went from $10 to $12, a whopping 20% increase. The honest business owner was forced to pass on the rising cost to pay for ingredients, electricity, rent, and labor to the customer to avoid bankruptcy. 

Knowing that the disposable income of its customers didn't rise per twenty percent overnight, the Taqueria's owner tried different solutions before raising its price. First, he reduced the size of the burrito and the quantity of food inside. Second, he decreased the quality of the ingredients by buying cheaper avocados, beans, and meat. Assuming he reduced the quantity by 10% and the quality by 15%. It means that, overall, the burrito is now 45% more expensive. After finishing up my burrito, I wondered how bureaucrats estimate inflation. 

The general price level is calculated using the Consumer Price Index (CPI). It's an index of a weighted average basket of consumer goods and services purchased by households. CPI is a proxy for inflation and thus is a crucial metric. People and businesses use CPI for their economic calculations. For instance, if prices rise by 6%, people need their disposable income to increase by six percent to maintain their living standards. Correspondingly, if a business targets a 3% real rate of return, with a six percent inflation, the nominal return target should be 9%. The same reasoning works with macro indicators with, for instance, the real gross domestic product (GDP) is the GDP inflation-adjusted. 

It's hard to calculate inflation. It requires compiling a lot of prices, adjusting for a decrease in size or quality, considering new products, and determining a relevant basket of goods for the average household. Needless to say that it's impossible to calculate inflation precisely, and over the past decades, the government has changed many times the way it calculates the CPI. Let's consider a striking example. Historically, CPI was calculated using a fixed basket of goods between two periods. If the same quality and quantity of burrito cost $10 before and $12 now, it's a 20% increase. However, nowadays, the CPI considers the change in purchases in response to price evolution. If I substitute my burrito for a "similar good" worth $10, the increase is 0%. The relevance of this change is controversial. 

The government has an incentive to lower the CPI. A lower CPI implies a higher real GDP, suggesting that the economy is more robust than the reality. It also reduces the state's expenditures by paying less social security beneficiaries or civil servants. Furthermore, it allows the government to print more money and add more debts misleading investors into thinking that bonds yields are positive. Incentives drive the world, so, understandably, people doubt the government's data on inflation.   

Estimating inflation is challenging, and no metric is perfect. However, one thing is sure: governments always inflate the money supply to fund their expenditures. The history of money is the chronicle of inflation engineered by governments. The dollar, one of the most stable currencies on the planet, had an average inflation rate of 3.87% per year between 1973 and today, meaning that the purchasing power of one dollar in 1973 is now 0.15 dollars. Money printing shrinks the middle class, increases the gap between the rich and the poor, and distorts economic calculation, preventing society's harmonious development. Looking at the U.S. money stock measure, the so-called M2, the Federal Reserve has recently printed a lot of money. It appears to be in line with the financial assets bubble and the rise of consumer prices. The question is then: how to survive inflation?

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