The Politics of Inflation & The Fed

What is inflation? That should be easy to answer. Inflation should be what people pay for things. However, politics and policy got involved, making things complex and confusing. The government told one generation of consumers that a specific set of goods and services was inflation, and for the next generation, inflation was something different. One generation of policymakers followed one price index, even with its imperfections, and the next generation followed something different, even though it had more imperfections.

Years ago, I created a broad price index, which included consumer, producer, and asset prices because all prices send signals that matter. A broadly defined transaction-based price index could serve as a valuable indicator of economy-wide inflation and end the politics of the numbers. The current reading of 4.5% is 100 basis points over the prior year reading.

Inflation & Measurement

Measuring inflation is a complex task, particularly regarding achieving real-time accuracy. However, there are some fundamental truths about inflation measurement. A price measure should capture the purchase price of a good or service that most households commonly consume or buy. A price index should not include any items that could lead to ambiguity or biases.

The Consumer Price Index (CPI), initially called a "buyer's index," was created to measure the purchase price paid by the consumer (i.e., households) for a fixed basket of goods. Yet, the politics of inflation got involved, and it is no longer a "pure" price index based on what people pay.

In the late 1970s, there was a lively debate over the construction of housing cost components in the CPI. Government statisticians and many in the academic world argued that it overstated housing and general inflation and recommended a change in the measurement. A panel of experts recommended the measurement of owner-housing costs shift towards a "rental equivalence," which purportedly measures the consumption of housing, not the investment part.

Congress approved the change because they felt a lower price index would help reverse the ever-rising budget deficit and federal debt as it should slow the rise in the inflation-indexation of social payments and lessen the impact on federal revenue through the inflation escalation of federal income tax brackets.

Rental equivalence is not observable since there is no cash outlay. Here's an example to better understand rental equivalence. Suppose a homeowner has an outside garden. Instead of consuming the garden's produce, the homeowner decides to sell it. So, one way to determine the inflation rate of homegrown food is to sell rather than eat it. However, if there is no sale how do you measure the inflation rate of homegrown food? It's arbitrary.

Today, the controversy over rental equivalence has resurfaced for different reasons. Some argue that it alone keeps reported inflation higher than it is and should be overlooked because reported inflation statistics are losing credibility. One of the reasons cited for changing housing costs in 1980 was that many people felt that the old way of measurement was "seriously flawed" and that to maintain "public confidence," the index must be changed. The politics of inflation never dies; only the actors change.

The Fed entered the politics of inflation two times. First, former Fed Chairman Alan Greenspan created a controversy in the mid-1990s when he argued that the CPI overstated inflation and the inflation rate should be reduced by one percentage point when used to index federal entitlements. That caused a massive scramble in Congress with a formal commission (Boskin) announcing the study of the CPI, which ended in a series of recommendations for methods to reduce the CPI and gave little attention to changes that might increase the index.

The second political-inflation decision by the Fed was selecting its price target as a policy tool. The old generation of Fed policymakers always viewed the CPI as the primary measure of consumer inflation in the US. Yet, the new generation of Fed policymakers chose the personal consumption deflator (PCE) as its primary price target.

The Fed defended its choice by arguing that CPI gave too much weight to housing, and the PCE measure allowed for product substitution due to price changes. However, the Fed failed to say anything about the PCE imperfections.

For example, the PCE is not a direct measure of consumer price inflation since 30% of it included administered prices for Medicaid and Medicare. Also, the Fed failed to mention that the PCE does not capture product substitution because detailed spending data for most goods and services does not exist in real-time but is available with a lag of one to five years. Nonetheless, choosing the PCE over the CPI was a convenient, if not political, way of producing a lower price index and, most importantly, making it easier for the Fed to say it achieved its targeted inflation rate.

Years ago, I created a broad price index after the former Fed Chairman asked the question, "Where do we draw the line on what prices matter?... Certainly the prices of goods and services now produced matter...But what about futures prices or more on future goods and services, like equities, real estate, and other earning assets? Are stability of these prices essential to the stability of the economy?”

Greenspan's remarks of 1996 proved prescient. The recessions of 2001 (tech bubble) and 2007-09 (housing bubble) were caused by the sharp reversal in asset price inflation.

Recent history shows the rising importance of asset inflation, making a solid case for a broad price index. My version of a broad price index included: • Consumer and producer prices (excluding food and energy prices at lower processing stages to avoid double counting). • New and existing house prices. • Equity prices.

The weighting scheme is consistent with the consumer, business, and housing sector shares in GDP, and the equity share was equal to the consumer saving rate. A current reading of the broad price index pegs economy-wide inflation at 4.5%, 100 basis points over the rate recorded one year earlier. The fast gain in asset prices has principally driven the acceleration, a sharp reversal from the previous twelve months.

Because price measurement is not what it used to be, nor what people think it is, the current version of prices is losing credibility. A recent paper by economists at Harvard and the IMF argues that the failure to include consumer borrowing costs as the old version did may help explain the disconnect between reported and experienced inflation nowadays.

The politics of inflation has resulted in unequal outcomes, as it focuses solely on one type of inflation and ignores and indirectly helps others (asset owners). History has shown that all kinds of inflation matter. So, it's time for monetary policy to ignore politics and focus on all the prices that matter. A broad price index would help improve the Fed's analytical inflation framework.