Inflation Is Broken

I have been writing for many years that the US in particular and the Western “developed” world in general were approaching a time where none of our choices would be good.

We have arrived. Any choice the government and central banks of the US and the rest of the world make will ultimately lead to a crisis. Just as the choices that Greenspan and Bernanke made about monetary policy created the Great Recession, Yellen and Powell’s choices will eventually lead us to the next crisis and ultimately to what I call The Great Reset.

I believe we have passed the point of no return. Changing policy now would create a recession as big as Paul Volcker’s in the early ‘80s. There is simply no appetite for that. Further, the national debt and continued yearly deficits force monetary policy to stay accommodative.

Today we will look at these problems through the lens of inflation. In general, consumers agree inflation is undesirable. They don’t want the prices of things they buy to go up.

But let’s talk about academics and central bankers. A little inflation makes sense from their viewpoint. They want to always have room to cut interest rates, should the economy falter. They would prefer to avoid negative interest rates. They need “normal” interest rates a comfortable distance above zero. That’s hard to maintain unless the economy has some degree of inflation. So, they tolerate a little inflation and, when necessary, actually encourage it.

But this raises another question: How do central bankers, or anyone else, actually know how much inflation exists? They depend on data, and data can be twisted, misinterpreted, or just plain wrong. Sometimes all at once.

I touched on this problem last week. So much of our broken economy is the result of broken monetary policy, resulting from broken data. This affects everything. If Federal Reserve officials think inflation is low when it’s actually high, or vice versa, they will set interest rates too high or low. Governments, businesses, and consumers will all make similarly bad decisions, all of which will eventually coalesce into a catastrophe like the Great Recession. And it will all trace back to a data problem.

Inflation is far from the only data problem, but it is probably the most consequential. So today we’ll dive deeper into this subject. Our distorted inflation data has a lot to do with housing “prices.” I use quote marks there because price may not be the right word, as you will see.

Housing vs. Shelter

We have to start with a definitional issue. For most people, housing is a major expense, and often the single largest one. Hence it is rightly a big part of the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE).

The Federal Reserve favors the PCE measure, while for whatever reason, the business media seems to focus on CPI. Typically, the core CPI and PCE move more or less in tandem. But notice that both measures use housing as their biggest component. This table shows the weightings.

Source: Wikipedia

Notice that owner’s equivalent rent (OER) in the CPI is 23.4%, but total housing costs are weighted at 42.4%. The BLS tries to take into account how many people own their home, rent their home, and then what the other costs of housing are. Some people own their home outright and other people have large mortgages. As you will see, there is a lot of guesswork involved.

First, do you actually “consume” housing? In one sense, no. The house is still there after you sleep in it, just slightly used. You didn’t consume the house itself. You consumed the shelter it provided you for that particular night. I know, a subtle distinction. But it matters to academics and the way we measure housing/shelter inflation.

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Norman Mogil 1 month ago Contributor's comment

Housing costs are more related to the price of land. Land does not appreciate and is different from housing on the land which does depreciate. This complicates the measurement of housing costs per se.