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Two days after the last Federal Reserve meeting on December 11–where they told us again that inflation continues to fall below the Fed’s 2% threshold and that, therefore, there’s no inflation to worry about–I walked into my favorite New York bagel shop, Absolute Bagel, to discover that the bagel bakery had posted new prices: Bagels would climb to $1.50 each from $1.25 where they had been priced for years. (I can remember a $1 bagel at Absolute but the price is lodged somewhere in the back of my memory along with a competent Knicks basketball team and the days when Greeks actually ran Greek diners.)

How can the price of a bagel go up by 20% in an economy with no inflation?

You’ve probably asked yourself a similar question after getting a higher bill from your wireless phone provider, or when buying chicken, or after paying the co-pay for your kid’s last physical.

For an economy with no inflation, it sure feels like there’s a lot of inflation going on.

Some of the explanation for this mismatch between statistics and your and my feeling is a result of the way that inflation gets measured by every scale from the Consumer Price Index, the inflation measure we’re most familiar with, to the Personal Consumption Expenditures Index, the Fed’s preferred measure of inflation. My family eats about 8 bagels a week (I did mention we live in New York City, right?) so that an extra $2 a week gets lost in the market basket of goods that any inflation measure tracks. And since a bagel falls into the “food” category, even that extra $2 gets stripped out when the government statisticians calculate core inflation, which doesn’t include changes in food or energy prices.

But a good part of the difference between the official call of “no inflation” and our feeling “yes inflation” comes from what I’d say is an important mis-understanding–of the psychology of inflation. Not by you and me. But by those folks at the Federal Reserve and the other bodies the calculate the inflation number and then use that to set monetary and fiscal policy.

I think the official inflation number badly misrepresents and under-emphasizes felt inflation. (Which I’m going to call “behavioral inflation” for there rest of this post.) And since we watch inflation because its ebbs and flows change behavior by everyone from consumers to bank CEOs this mis-representation of inflation has huge potential effects on the economy. And right now, I’d argue, those mis-representation effects are almost totally negative and dangerous to the U.S. and other economies .

I was pleasantly surprised last week when I read the minutes from the Federal Reserve’s December 10-11 meeting. The Fed is, I’m glad to see, worried about the lasting negative effects of the current extended period of extremely low rates.

Me too. I wonder if this long period of cheap, cheap money has led traders and investors to believe that markets alway go up because the world’s central banks will always show up to backstop any downturn. That’s likely to lead to some pretty distorted ideas about how much risk there is in the financial markets and to encourage risky risk-taking.

To its credit the Federal Reserve is worried about those things too. (Although not so worried as to summon up the institutional will to take the political heat for doing something about that problem.)

And the Fed is also worried about the effects of the current long, long period of extremely low inflation. American expectations, the Fed said in its minutes, for future inflation are too low. And those low expectations for future inflation can lead to behavior that distorts the working of the economy.

Hunh? The Federal Reserve’s data may show a continued condition best described as “no inflation.” After its December 11 meeting the Fed’s Open Market Committee said that overall inflation and inflation for items other than food and energy are running below 2%. In its projections released on that date, the Fed concluded that all-items inflation (using the Fed’s preferred Personal Consumption Expenditures measure of inflation) would run at a 1.6% rate in 2019 and that core inflation (that is inflation without food and energy prices) would be 1.6% for 2019. In 2020 all-items inflation would climb to 1.9% and core inflation would match it at that rate. Looking further down the road, the Fed sees 2% inflation in 2021, 2022 and as far as the eye can see. In other words, in the context of the Fed’s goal of balancing inflation and economic growth, no inflation.

But I think the Fed’s data driven view of the world has led it to badly misunderstand the realities of inflation for most U.S. consumers. And the peculiar psychology that is now in place for those consumers about inflation and the economy.

Let me give the Federal Reserve, and you, a tour of inflation in the real world as I, and I think most U.S. consumers, see it.

Let’s take a not-so-deep dive into how the government and private sector economists see inflation. The figure isn’t some objective, real life measure of all the prices in the economy. That would be impossible and it’s not even clear that it would be terribly useful. Amy inflation number has to start with some “market basket” of goods that represents what a consumer buys. (I buy, for example, things other than bagels.)  That market basket of prices is then massaged to account for things like “substitution,” the likelihood that a consumer faced with a 25% increase in the cost of his or her daily bagel will switch to, say corn or blueberry muffins.(Judging from the endless lines outside Absolute in my neighborhood after the price increase, there’s not a lot of switching going on.) And the statisticians go further to venture into the controversial world of heuristics. This approach to inflation calculations argues that we should factor in improvements in the performance of goods–a $795 computer today does more work than a $795 yesterday–into the price of a good or service. Perhaps an Absolute bagel today can carry more cream cheese than the bagel model of a year ago and that would reduce the impact of that 25% increase in market price.

It’d worth arguing about all these technical arguments. (And I’m in the camp that suspects that heuristics became more important in inflation calculations when the government wanted to reduce the inflation rate for budget purposes.) And I think it’s important to get purely statistical inflation numbers as accurate as possible.

But these technical arguments miss the big point: Current methods for measuring inflation don’t adequately include the way real people spend real money and the way that they feel about spending money based on the way they feel about prices and the economy. And therefore the official numbers miss the way that increases and decreases and seeming price stability determine how inflation feels to us in our every day lives. And the way that this “behavioral inflation” determines how we make decisions such as asking for a raise, or saving, or spending money at a store, or running into debt.

Let’s take a look at drug price inflation. On July 1 , 2019, Kaiser Health News reported that the price of 104 brand-name and generic drug rose by a 13.1% on average year over year, compared to a 7.8% average year over year increase for 318 products a year earlier. Politico calculated that drug prices had climbed 10.5% in the first six months of 2019. That was, Politico noted slower drug price inflation than in the first six months of 2018. But still roughly five times the overall inflation rate. And this has been going on and on and on. The American Association for Retired Persons (which is a source with a statistical ax to grind I’d admit) notes that if the average annual cost for a drug used on a chronic basis had increased at just the general rate of inflation from 2006 to 2017, the cost of that drug would have been more than $12,500 lower in 2017 ($7,263 v. $19,816.)

Now drug prices are figured into the general rate of inflation–you know the one that says inflation is below 2%–but look at drug inflation from a behavioral viewpoint.

First, once you’ve switched to a generic (if that’s possible for you) you have very limited powers of substitution.

Second, note the implications of the AARP numbers: drug prices have been on an upward march for years. The AARP found that drug prices had increased at a rate higher than the rate of general inflation for 12 straight years as of 2017. And the rate of increase for what AARP calls “widely used specialty drugs” have climbed by an average of 7% in 2017 to a whopping average annual cost of $78,871.

If the Federal Reserve is worried about the long-range effect of low inflation–sub-2%–think about the behavioral effects of this long period of drug price inflation above the rate of general inflation. People who need these drugs don’t have an alternative. They must assume by this point that this above-general-inflation increase in drug prices is forever. No wonder that there is such a heated demand for government action to break the trend and such concentrated dislike for drug companies. Or that there are people in the United  States who skip their medicines or substitute drugs for food or who are using versions of their drugs approved for animals (but not humans) since veterinary drugs tend to be cheaper.

Or take a look at college tuition inflation. This is another case of non-substitution since with the collapse of state government funding for state universities (States on average spent 13% less per student in 2018, adjusted for inflation, than they did in 2008, the beginning of the Great Recession) the net cost of going to a public university is–for an out of state student–roughly comparable to the net cost of attending a private university offering bigger financial aid packages than public universities offer to out of state students. From 1980 to 2014 tuition inflation was 260% versus 120% for all consumer items. The College Board now starts off its financial advice by saying “Assume that college costs will increase by 8% a year.” That seems high in comparison to the estimates but I can’t find any source that pins inflation even for public universities at less than 4% and 5.5% seems  a more widely shared number.

As with drug prices, the evidence is that tuition inflation of 2x to 2.5x general inflation is now baked into expectations. And again, as with drug price inflation there seems no way reasonable substitution available. (You OK telling your bright and hard working high school teen that whereas you went to college, he or she can’t? Isn’t the American guarantee that each generation has it better than its parents?) That’s why we’re looking at a student debt crisis that looks to be getting even worse and that shows no signs of ending on its own.

And while we’re talking about “substitution,” let’s look at how substitution is working right now for many of the goods we buy. Tried on  pair of jeans lately and felt the fabric wasn’t as hefty as you remember? Manufacturers in an effort not to raise prices have indeed cut the quality of raw materials and have hoped that we haven’t noticed. This has become especially wide spread in the aftermath of the U.S. tariffs on imported raw materials. Manufacturers have cut raw materials costs wherever they can in an effort not to hurt sales when customers decide to put off a purchase or switch to an overtly cheaper product. But this kind of what I’d call negative substitution–the price stays the same but the quality/functionality of the good or service declines–dates in my own experience to well before the tariff wars. I remember having a relatively honest conversation with a salesman in a running shoe store where I’d gone to finally replace the very beat-up pair of New Balance running shoes that I use for getting around day to day in New York. (I am not a runner just a guy with high arches.) The salesman, after noting that I seemed to have bought my shoes about 8 years ago, told me that I shouldn’t expect the shoes he was about to sell me–at an Federal Reserve official inflation-adjusted price very similar to that I’d paid so long ago–to last as long as my old pair. Most running shoes these days were made in factories in Vietnam or other developing economies using cheaper materials. The life expectancy of my new shoe would be about a year. Now I wasn’t born yesterday and I know this guy’s job to to sell me running shoes as frequently as possible. But my real life experience is that indeed whatever new running shoe I buy it is only good for about a year. And then if I want to arch support that I need so my walking around life isn’t miserable, I have to buy new shoes.

All this “behavioral inflation” isn’t taking place in an economic vacuum. One of the great debates about the U.S. economy since 1980 or so is why median incomes have risen so slowly in real terms. Real median household income in the United States increased 0.8% to $61,937 between 2017 and 2018, according to the Census Bureau. Note that while this figure is for real income–that is after inflation–the gain in real income would disappear if the inflation rate was just one percentage point higher than the Consumer Price Index says it is. Median real household income has increased in every year since 2013 with the year to year real increase in 2018 from 2017 smaller than the 1.8% to 3.3% median increase in the previous three years. The Census Bureau reports that 2018 was the second consecutive year that U.S. median household income was higher than 2005, the year when the Census Bureau began collecting this monthly income data.

There’s another real income figure to look at when judging the effects of the potential difference between official inflation and behavioral inflation.  And that’s the annual increase in the Social Security benefit as a result of adjustments for the cost of living. In 2020 the adjustment will amount to 1.6%. Cost of living adjustments over the last decade have averaged 1.4% with no increase in 2010, 2011 and 2016. The cost of living adjustment is based on the Consumer Price Index, which as I’ve outlined above is based on general inflation on a defined market basket. Senior citizens–full disclose I’ll turn 70 next week–however are a group with a significant difference between that market basket and what they actually purchase. From January 2000 to January 2019, the Senior Citizens League calculates that cost of living adjustments added about 50% to Social Security benefits. (If you’re looking for a reason for the U.S. budget deficit crisis, you could do worse than start here.) But the Senior Citizens League found that the costs of goods and services frequently purchased by Social Security recipients climbed by more than 100% during that period. In real experiential terms, in terms of behavioral inflation, Social Security benefits have lost one-third of their buying power since 2000. (If you’re looking for the source of another crisis in the U.S. economy–the squeeze that the youngest wage earnings are feeling–you should also start with this Census Bureau data. Real median house income at the end of 2018 was $75,289 for household ages between 45 and 64. It was $68,817 for household ages 25 to 44 at $68,817. For households with ages under 25 it was just $33,389. I know we expect that for workers just entering on their career incomes will be lower (and that some in this youngest age group aren’t fully in the labor force) but the gap between $75,289 and $33,389 per household is still shocking to me.

If you’re looking for why so many Americans feel so economically pressed, I think you need to include this difference between official inflation and what I’ve called behavioral inflation. And if you looking to explain some of the trends in the U.S. economy now (rates of home buying, for example)–and to come–you also need to factor in this difference.