The Fed Must Target "Actual" Inflation

With price stability as a key mandate, the Federal Reserve bears a significant responsibility to guarantee that the targeted price statistics accurately reflect people's experiences and are not influenced by political or statistical manipulation. However, the Fed's price targeting regime has become misleading and unbalanced since the price measure it targets has become less relevant to "actual" inflation. The Fed nowadays lacks a "Greenspan," or an individual who is both an expert in economic statistics and methodology and possesses the political power and influence to challenge the accuracy of published statistics or request their review. The matter of accurate price measurement is not just academic; it has real economic and financial effects.

Years ago, the Price Statistic Review Committee (PSRC), a group of academics, economists and statisticians, stated that, “If a satisfactory rent index for units comparable to those that are owner-occupied can be developed" then the committee recommends that BLS to use this approach for house prices and related expenses.

The General Accounting Office (GAO), which released a comprehensive report on how housing costs are measured in inflation metrics, made a similar suggestion. The GAO stated, "Most owner-occupied housing units differ significantly from many rental units. To apply rental equivalence in the CPI, a sufficient number of rental units must be identified that are comparable to owner-occupied units in terms of size, location, and quality, allowing the BLS to create a sample that accurately reflects owner-occupied houses."

In 1983, based on recommendations from the PSRC, GAO and others, the Bureau of Labor Statistics introduced the owners' rental equivalence method to estimate housing costs of owner-occupied homes. This estimation procedure continued until 1998, when the BLS announced that it had to discontinue the owner-sample due to an insufficient sample of owner-housing units. Moving forward, they decided to link the rent estimates for owners' rent to the other rent series. Neither the PSRC nor the GAO provided any comments.

The owners-occupied rent series constitutes roughly fifteen percent of the Fed's preferred price target, the personal consumption expenditure deflator (PCE). Combined with the thirty percent of the PCE that individuals do not buy, nearly half of the PCE deflator reflects an inflation rate derived from administered and non-market prices or imputations. How can this be regarded as a reliable or accurate measure of actual inflation people experience?

Price data should represent "actual" inflation, not a statistical distortion. Considering its essential role in shaping both monetary and fiscal policy, it is crucial for the price data to be accurate, relevant, and objective. The general public benefits from "actual" sustainable low inflation. But who gains when inflation might be understated, or its cyclical fluctuations are dampened or eliminated due to a new statistical method?

Over the past sixteen years, from 1998 to 2024, the average S&P 500 P/E ratio was 26.7. In contrast, during the preceding fifteen years, from 1983 to 1998, it averaged 15. Is this just a coincidence, or could the alteration in inflation estimation for housing costs, combined with the Fed's emphasis on an inflation measure representing only half of the actual inflation rate experienced by people, partly explain this shift? This misleading measure of inflation and policy approach has led to maintaining official rates lower than they might have been otherwise, which benefit finance, especially equity investments.

According to history, "Washington" is unlikely to change it frameworks (price and policy) unless another crisis occurs. The financial press could increase public awareness of this issue, but it has not done so yet. As long as the existing price and policy frameworks remain in place, finance benefits while "Joe Six Pack" loses ground to "actual" inflation.