The economy is growing, unemployment is low, wages are rising and inflation is falling. However, the American people remain surly about the state of the economy. This puzzle has just been studied by four economists. They found that people often know something is wrong even if the statistics don’t reflect the problem. In this case, people perceive that inflation is, in fact, still high.
For months now, Americans have been told that the downward trend in inflation, from nearly 9% annually to around 3%, should make them feel good about the economy. But it does not work. A recent Gallup poll found that 63% believe the state of the economy is getting worse and 45% think it is already “poor.” Many have speculated that one reason is that, although the rate of price increases may have slowed considerably, prices remain very high. Food and rent in particular are still expensive. These prices are felt every day by Americans when they pay for housing and go to the supermarket.
But that is not all. A new study from the National Bureau of Economic Research by economists Marijn Bolhuis, Judd Cramer, Karl Schulz and Larry Summers finds that a change in the method used to estimate inflation today, compared to the method used in the 1980s, could cause an underestimation the real level of inflation.
The article – “The cost of borrowing is part of the cost of living” – highlights the overlooked impact of higher borrowing costs that consumers have faced in recent decades. From mortgages to auto loans to credit card debt, these costs are on the rise.
As the authors explain, the pre-1983 measure of inflation (the consumer price index) counted the price and interest rate Americans paid to buy homes. The latest measurement is based on how much it costs rent housing. Another way to think about it is that if you buy a house this month, your monthly payments will be much higher than if you bought it three years ago. The same goes for a car or other purchase. But measuring inflation based on rental costs – which may not incorporate the sky-high interest rates of a new purchase – does not reflect this difference.
As Summers, Treasury Secretary under President Bill Clinton, noted on X, formerly Twitter: “Before 1983, mortgage costs were in the CPI just as car payments were before 1998. Now, prices do not include borrowing costs. Therefore, when interest rates rose last year, official inflation did not fully capture the effects it would have had on consumer welfare.”
In fact, if we measured inflation as we did in the 1970s, inflation starting in 2021 would have peaked at 18%, double the reported peak. This is higher than the worst of the 1970s and 1980s. The current annual rate of inflation would be around 8%.
As Summers notes, measuring inflation according to the pre-1983 method helps explain “70% of the gap in consumer confidence we saw last year.” He is not surprised that Americans have a better sense of the state of the economy and their daily lives than economists who focus primarily on data, models and indexes to gain insight into the world.
I expect this article by Summers and co-authors will revive the debate about how we should measure inflation. John Cochrane, al Grumpy economist Substack, notes that to answer this question correctly, you must first ask yourself what you are trying to measure:
The new way is closer to the right, if the question is measuring changes in the cost of living right now for the average person… Most people live in older homes with fixed mortgages, so higher prices and mortgage rates high for new homes do not. influence them. Those who rent don’t care. While higher interest rates are a cost to borrowers, and higher home prices are a cost to buyers, higher interest rates represent higher income for savers, and higher home prices are a benefit for those who downsize. Those wash on average.
But if the question instead is whether Americans believe their lives are getting better than they were a few years ago based on the idea that inflation would be declining and that they could rent a house just like theirs for less money, then the answer she is different.
The bottom line is that while the question of how best to measure inflation has no single, direct answer, one mystery has clearly been solved by Summers and his co-authors. People are not crazy. Even though all the media and the president keep insisting that life for ordinary Americans is getting better thanks to falling inflation, we know that’s not right.
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