The Camry-Effect (or why inflation is actually even lower than its already low reported rate)

Inflation is under-reported because products are evolving faster than prices are rising. This should color the Fed's decision about raising rates this week.

There is no good way to adjust this year's incomes to account for the fact that you can buy things that didn't exist last year. Before 2000, drivers in the US couldn't buy a hybrid car, in-car navigation, or an iPod (or iPhone for that matter) to be used for playing favorite tunes while commuting.

How do you capture inflation or deflation on products that didn't previously exist? Imagine an inflation report in the year 2002: "The price of a loaf of bread went up 2% this year. The price of a camera phone either soared or plummeted, we're not sure which. The argument for its price soaring is that last year it cost nothing and now it costs something. The argument for its price plummeting is that last year you couldn't buy one for any amount of money and this year you can afford one for some amount of money. Our inflation-calculators aren't sure where to go on this one."

The rate of new product introduction even muddies the true price of old products. Cars, for instance, continue to accumulate new and better features.

Let me illustrate this with a Camry, one of the most popular cars sold in the US.

You can buy a 2015 Camry LE (their basic model) for $22,970. At the start of the century, you could buy that Camry LE for only $20,388. If you were to calculate inflation assuming that the 2000 LE and 2015 LE were the same product, you would say that prices were rising 0.8% - less than one percent - a year. That is a low-rate of inflation but even that estimate may be too high.

As a product, the 2015 LE is actually more like the 2000 XLE - Toyota's top of the line Camry. The 2000 XLE sold for $24,068. If that is the comparison, prices have actually been dropping at about 0.3% a year, not gradually inching upwards.

How does the 2015 LE compare to the 2000 XLE? Is the old fancy the new plain?

The 2015 LE engine gets better mileage and has more horse power than the 2000 XLE. The mpg has gone up. In 2000, the XLE got 30 mpg highway and in 2015, the LE gets 35 mpg, an uptick of 17%. It is not just more efficient. It is more powerful. The 2015 LE's horsepower is 30% higher than the 2000 LE. At its core - its engine performance - this year's base model is better than 2000's luxury model.

What about features?

The 2000 XLE has two features that you'd have to pay extra for on the 2015 LE: automatic climate control and a power moonroof.

By contrast, the 2015 LE includes eleven features that weren't even available on the 2000 XLE: MP3 compatibility, steering wheel mounted audio controls, delay-off headlights, outside temp display, low tire pressure warning, electronic stability, traction control, brake assist, dual-front side airbags, overhead airbag, and a knee airbag. What was once not even an option on the luxury car is now standard equipment.

If I could bring the 2015 LE back in time to sell alongside the 2000 XLE,  I could actually sell it for more. Today's standard car is more luxurious than 2000's luxury car. But let's be conservative and say that the XLE;s moonroof is enough to offset its less impressive engine and other features. Let's simply say that today's LE is worth the same amount as the 2000 XLE. To repeat, today's LE sells for $22,970 and the 2000 XLE sold for $24,068. If you could buy LE's today and - with a time machine - sell them in 2000, you'd actually make money. That's something but whatever it is, it's not inflation.

The Camry is not unique. Products are getting better faster than they're getting more expensive.

Since the summer of 2012, inflation has hit the Fed target of 2% only a couple of months. The Fed already knows that it is low. And obviously, the experts know about this Camry-effect but calculating its impact on the inflation consumers experience is tricky. Again, do you assume the prices of new products or features has soared or plummeted? This assumption makes a huge difference to your basket of goods.

Things that are scarce - like beach front housing or any urban housing with a reasonable commute - are going up in price. As long as incomes and / or populations continue to rise, so will the prices of such scarce goods. But things that can be mass manufactured are going down in price. And the twin forces of globalization and product innovation are going to continue to put downwards pressure on these prices.

Since the 1970s oil shocks jolted prices upwards, there have been jeremiahs predicting hyper-inflation. Every time the Fed engages in something like Quantitative Easing - QE - by pumping billions or trillions into the economy, people get nervous about inflation. But the inflation never comes.

Obviously, it is still possible to have inflation kick in because of reckless monetary policy. Less obviously, that possibility has never been lower.

What is the punchline in regards to the Fed's decision next week to raise interest rates? Inflation isn't just low: it's lower than you think it is. Monetary policy is not too accommodating. If anything, it is not doing enough to allow for the rate of innovation and progress in products. If we want that progress to continue, there is no reason to start fighting inflation with higher interest rates.