Viewpoints

What accounts for the big disconnect between people's inflation and policymakers' inflation? People consider the total costs of things; based on that measure, inflation remains relatively high. Policymakers view inflation differently, creating a disconnect. Analysts should call out the disconnection and help the Fed avoid another policy blunder.

Inflation Based on Total Costs

People's inflation views are based on the total costs of things; yet, nowadays, inflation measurement is based on list prices/cash transactions ( and excludes financing costs), which makes little sense as fewer and fewer cash transactions occur.

When it comes to measuring inflation, it's crucial to take into account the total costs of goods and services, which includes financing costs. These costs are not only significant in individuals' purchasing decisions but also have a direct or indirect impact on their inflation expectations.

The influence of financing costs on inflation measures is particularly evident in the case of high-value items like vehicles. Here, financing plays a substantial role in determining the total cost of an item. With the prevalence of credit used to finance almost all consumer expenditures, incorporating financing costs in inflation measures could provide a more accurate reflection of people's perception of the cost of goods. A recent study by economists from Harvard and the IMF demonstrated that reported inflation would be significantly higher if current measurements included financing costs.

The PCE measurement method, meanwhile, which policymakers focus on, is notably disconnected from the inflation experienced by the public. It only captures a little over half of what people actually pay. This disconnect is attributed to various factors, such as the exclusion of financing costs and the use of a non-price measure for owners' housing.

Additionally, roughly a third of the index includes administered prices for government-subsidized items (such as health care) or items people never pay for. The PCE index, a hybrid of market and non-market prices, is inherently ambiguous, and for it to track people's inflation would be more a matter of luck than design.

Analysts should call out the disconnect between people's and policymakers' inflation as it raises the possibility of a major policy blunder. That's because policymakers consider the current stance of monetary policy restrictive, wrongly comparing the official rate level to an inflation measure disconnected from people's inflation. However, comparing official rates to people's inflation, which includes financing costs, monetary policy remains easy—which is what the financial markets have been saying for some time.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in April were mixed. Montana’s index rose a robust 1.2 percent from March, and three other states (Arizona, Maine, and Vermont) had gains above.5 percent, but six states, primarily from the middle parts of the nation, saw declines, with Ohio down .3 percent. Over the three months since January, 11 states, all across the nation, had increases of more than 1 percent, with Arizona up 1.8 percent. In contrast, 17 states had gains under .5 percent, with 4 of those experiencing declines. Over the last 12 months, Massachusetts was once again on top, but its increase of 3.6 percent---just edging out Arizona--was somewhat unimpressive in magnitude. There were four other states with increases higher than 3 percent. On the down side, five states had declines, with West Virginia down 2.4 percent (Montana was off 1.4 percent, despite its strong April), and 12 others had increases of less than 1 percent.

The independently estimated national figures of growth over the last 3 (.7 percent) and 12 (2.8 percent) months appear to be roughly in line with the state numbers.

In discourse about CO2 emissions, the focus is often on the emissions resulting from the production of goods. Many countries have made great strides in bringing down their emissions from production. For instance, according to EDGAR data, the United States has cut its emissions from manufacturing and construction in half over the past 50 years. Likewise, many European countries, including Germany, have made even more dramatic cuts in their emissions from goods production. While this is certainly a step in the right direction, it appears that these statistics overstate the progress in lowering emissions and mask underlying developments that make real cuts more difficult.

The fact is, major economies are able to outsource their production of goods while maintaining high consumption. This is highlighted by the US trade deficit of over $1 trillion per year in 2021 to 2023. While the trade deficit is less than 5% of the US GDP, the composition of the deficit is heavily weighted towards goods, which entails a disproportionate amount of emissions in production. The tendency to outsource goods production makes US and EU emissions figures look better than they are and emissions figures from countries like China and other Asian nations look worse. IMF data showing CO2 emissions embodied in US trade vs US production emissions highlight the problem (see Figure 1). Total emissions produced in the US have drifted down in the past decade, but the jump in trade in the past three years has offset that improvement. Not only has this development skewed worldwide emissions figures, it has pushed production to parts of the world where emissions standards are lax. However, a focus on emissions from the consumption of goods rather than production presents an alternative view in finding solutions to tackle climate change.

The main idea is that demand for, not production of, carbon-rich products drives emissions. If no one wanted to buy the product, no one would produce it. The US and European nations have been importing more and more goods, which are heavy in carbon content, and therefore avoiding some production of emissions. But the emissions are being produced nevertheless. To put the figures in perspective, according to the IMF emissions embodied in trade data, the amount of emissions the US imported was nearly as great as all emissions produced in India, with its 1.4 billion people. By our estimates, trade accounts for about a quarter of all emissions from US demand.

Both importing and exporting nations benefit from trade in these goods. Those countries that are exporting goods to the US and Europe enjoy a comparative advantage, which means they can produce them at lower cost. However, part of the comparative advantage may be the ability to pollute without political ramifications. No doubt, the production processes employed to make the products abroad entail more emissions than if they were produced domestically. We can see this by comparing US NIPA data with the emissions in trade data. In 2021, the US imported $2.842 trillion worth of goods and that accounted for 2,243 million metric tons of CO2. Meanwhile, the US exported $1.746 trillion worth of goods and that accounted for 627 million metric tons. So, US imports were 63% higher, but emissions from US imports were 258% higher. The carbon content of the products the US imports is much greater than the carbon content of the products the US produces for export.

So what can be done about this? The focus on consumption offers a solution using leverage from trade. Worldwide emissions from manufacturing can be reduced through carbon taxes on end consumers in United States and Europe, and subsidies for products that already have adopted cleaner processes. This would evade a damaging trade war as the tax would apply to all goods irrespective of country of origin. A carbon tax on consumption likely would impact producers, creating an economic incentive to producers everywhere to reduce emissions. Those countries that produce with heavy carbon footprints would have the most incentive to find innovative solutions in their manufacturing and production processes or alternatively use green energy. The higher price consumers pay would align better with the true costs to society for these products. On the government side, the US federal government, being one of the largest purchasers in the world, is already aiming to make federal procurement net zero carbon emissions by 2050 as a part of its sustainability goals.

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.

State labor markets were mixed to moderate in April. Six states had statistically significant gains in payrolls , with the most impressive gains Missouri’s .6 percent increase and Florida’s 45,300 (.5 percent). The other states, and DC, had changes deemed to be insignifcant, including New Jersey’s drop of more than 10,000 (.2 percent).

Five states had statistically significant declines in their unemployment rates in April, and two had increases. None were larger than .2 percentage point. The highest unemployment rates were in California (5.3%), DC (5.2%) and Nevada (5.1%). No other state had rates as much as a point higher than the national 3.9%. Maryland, Massachusetts, Minnesota, Mississippi, Nebraska, New Hampshire, North Dakota, South Dakota, Utah, Vermont, Virginia, Wisconsin, and Wyoming had rates of 2.9% or lower, with both Dakotas at 2.0%.

Puerto Rico’s unemployment rate was unchanged at 5.8 percent, while the island’s job count moved up by 1,200.

Yesterday evening, May 8, Erin Burnett, host of CNN’s “Erin Burnett Out Front”, interviewed President Biden. When Ms. Burnett was with Bloomberg News, she was my favorite presenter because her facial expressions indicated whether the person she was interviewing was saying things that were illogical or were fabrications. So, it was with some disappointment when Ms. Burnett made some false or misleading statements when interviewing President Biden yesterday evening about the state of the US economy.

Ms. Burnett had a lot to say about the higher inflation that exists today compared with February 2020. Yes, as shown in Chart 1, the year-over-year percent change in the Personal Consumption Expenditure (PCE) chained price index was 2.71% in March 2024 compared to 1.64% in February 2020. Ms. Burnett received a BA in economics from Williams College. Did her macro and money/banking professor not teach her that inflation is everywhere and always a monetary phenomenon? And what quasi-government agency in the US is responsible for monetary matters?

The widely followed employment cost index (ECI) jumped 1.2% in Q1 2024, faster than the 0.9% increase in Q4 2023, raising fears that labor costs are re-accelerating. As big as the jump in the ECI was in Q1, another labor cost measure (ECEC) shows employee costs are rising even faster.

The Bureau of Labor Statistics, the government agency in charge of reporting labor market data, provides two crucial measures of employee costs: the employment cost index (ECI) and employer costs for employee compensation (ECEC). Both measures, with a similar scope covering 5500 to 5600 private industry establishments and 23000 occupational observations, play a pivotal role in labor cost analysis. However, it's important to note that the ECI excludes employment shifts among occupations and industries, while the ECEC does not, making the ECEC an equally important comprehensive measure of total current employment costs.

The two measures are simple to understand: the starting point for both measures is the change in wages, but if people move to higher-paying jobs or shift occupations because of the promise of higher pay, the ECEC measures will grow faster than the ECI. In contrast, if the opposite is true, when the jobless rate is high, job openings are low, and people have to accept lower-paying jobs, the ECI would increase faster than the ECEC.

In the last several years, the labor market has been characterized by a record number of job openings, which have encouraged people to shift industries and occupations in search of higher pay. The labor cost data confirms this did happen. Private industry wage costs in the ECEC have outpaced the increases in the ECI every year, and the increase in 2023 of 6.9% was the largest on record and 270 basis points over the increase in the ECI.

The Q1 2024 report for ECEC is due on June 18. Based on the still high number of job openings and low jobless rate, the Q1 rise in the ECEC index should exceed the ECI increase, adding to current fears of higher labor costs feeding into inflation numbers.

The US economy is stronger than suggested by the “soft” 1.6% increase in GDP in the first quarter, while a sharp upturn of inflation puts Fed rate cuts on hold for at least several months.

Look to final sales to private domestic purchasers, not GDP, for a better indication of the economy’s underlying strength. The initial (“advance”) report of the national accounts for the first quarter of 2024 should be interpreted carefully. Looking beyond the headline figures, the economy’s underlying growth momentum was notably stronger than the disappointing figure of 1.6% quarterly GDP growth in the first quarter. GDP growth was held down by declines in components that tend to be more volatile --- inventories and net exports --- in contrast to solid growth in other components, including consumer spending and private investment. Personal consumption expenditures (PCE) posted solid growth (of 2.9%). Business fixed investment also rose 2.9%, while residential investment jumped 13.9%, continuing a recovery that began in the second half of 2024.

A more telling indicator of the US economy’s underlying strength is final sales to private domestic purchasers, which rose at a solid 3.1% annual rate in the first quarter, virtually identical to increases in the third and fourth quarters of 2023 of 3.0% and 3.3%, respectively. This is a clear if preliminary indication that the economy retains solid momentum for growth.

Together, declines in inventory investment and net exports subtracted 1.2 percentage points from GDP growth in the first quarter, but those components are not likely to continue to subtract large amounts from GDP growth on an ongoing basis, even though quarterly swings could be significant (in either direction) from time to time. The level of inventory investment ($35 billion in the first quarter) is broadly sustainable, suggesting that repeated large declines are not the most likely outcome. Net exports have been in a sideways waffle since the second half of 2022. Future large declines are possible if foreign demand were to collapse or the dollar were to appreciate sharply, but neither of those outcomes appear to be highly likely at this juncture. In short, the 3.1% growth in final sales to domestic purchasers is a better indicator of underlying strength in demand than the smaller 1.6% increase in GDP in the first quarter.

Of course, GDP and other estimates are subject to revision, so the picture of first-quarter growth could be altered in coming months.

Inflation surged in the first quarter, nearly eliminating any prospect for a Fed rate cut prior to this fall. Another major component in today’s report on the national accounts was a disturbing increase in consumer inflation. The price index for personal consumption expenditures (PCE) rose at a 3.4% annual rate in the first quarter, the largest increase since the first quarter of 2023. Meanwhile, the core PCE price index rose at an even higher 3.7% annual rate in the first quarter, far above the increase of 2.0% in the final two quarters of last year. This is a direct challenge to any hope that the Federal Reserve will begin to lower interest rates in coming months. As of the first quarter, the annual (four-quarter) increase in the core PCE price index was 2.9%. It is likely that tomorrow’s report on monthly PCE will show annual (12-month) inflation at or slightly above February’s 2.8% reading.

The Federal Open Market Committee (FOMC) will almost certainly not begin to seriously contemplate rate cuts without clear indications that inflation is easing and well on track to fall to 2% over time. The latest inflation figures suggest that progress on bringing inflation down has stalled. It will take more than one or two “good” monthly inflation reports to convince policymakers that it is appropriate to begin cutting interest rates. This makes any rate cut prior to this fall a low probability outcome and adds to the risk that there might not be any Fed rate cut in 2024.