Flawed inflation tracking and how to correct it

🔬Understanding the problem 

If 2022 peak inflation had been measured the same way it was in 1980, it would have been 18% not 9.1%

In this new NBER working paper, The Cost of Money is Part of the Cost of Living: New Evidence on the Consumer Sentiment Anomaly four economists piece together new insights on why today's inflation figures do not accurately reflect the economic impacts being felt by individuals and families today.

One root cause: Key indicators have been removed from the consumer price index

• In 1983, mortgage costs were removed from the consumer price index (CPI)
• In 1998 car payments were removed from the index 

When the 2023 interest rate hikes occurred, official inflation figures did not reflect the full impact on people because the measures do not include the cost of borrowing.

Individuals and families feel CUMULATIVE inflation more strongly quarterly or monthly inflation

In May 2024, cumulative change in inflation since 2021 was 19.3% - meaning the prices people are paying were averaging about 20% higher than 3 years ago. That's a very different inflation figure from the then official current claim of 3.36%. Three percent doesn't sound too bad, but that's not what's shaping the lived experience of individuals and families noticing that its harder and harder to live within their budgets.

The makings of our current inflation situation are not recent: we've had inflation for some time now, and just weren't tracking it completely. Here's what to understand:

• Two measures are used - CPI and PCE - both explained here. CPI guides Social Security payments, while PCE guides Fed inflation controls. 
• Investopedia has helpful introduction to the concerns about whether or not the current federal methods are able to accurately track inflation.
• A dated but official position of BLS on CPI seems to be "it's mostly accurate, but it could be inaccurate and well, its complicated."  

These standard measures seem to have a bias toward a 20th century economy where everyone just consumed manufactured goods, which were produced at lower and lower costs as factories moved to countries with lower wages. The dramatic rise in productivity masked the true inflation that was occurring.  

Current inflation measures tend to average different kinds of costs ...the cost of a TV, the cost of healthcare, etc. Some of these costs over time have increased sharply while others have decreased. The cost of a TV has fallen over time. However that decrease in cost does not offset the fact that the cost of healthcare has risen sharply over time, and continues to rise. People buy TVs maybe once every 2 years. People pay for healthcare every month. So the impact to household budgets is different. 

And, as this thoughtful piece points out, federal inflation measures do not track the cost of funding your retirement.

Proposal: Redesigning Inflation and Economic Measures to Reflect Actual Financial Experiences of Individuals and Families

Problem Statement

Current inflation measures, such as the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE), fail to accurately reflect the real financial pressures faced by individuals and families. These measures often average disparate categories of costs, masking critical disparities in their financial impact. Furthermore, inflation measures do not connect the dots between a family’s after-tax earnings and their monthly expenses, leaving a significant gap in understanding the economic challenges faced by various income levels.

Key Issues with Current Measures

1. Disparity in Weighting Costs: Inflation measures average costs like televisions (which have decreased in price) and healthcare (which has risen sharply). Since healthcare is a recurring expense while TVs are purchased infrequently, this averaging yields economic indicators that don't reflect the true financial burden households are experiencing.
2. Disconnect Between Income and Expenses: Current measures do not effectively evaluate the relationship between after-tax earnings and essential living costs. They fail to reveal the percentage of the population earning enough to cover non-negotiable expenses, savings, and discretionary spending.
3. Lack of Forward-Looking Insights: Existing metrics do not account for the cascading effects of income inadequacy on public health, housing markets, poverty, and societal unrest, leaving policymakers in the dark about critical warnings and insights for long-term planning.

Proposed New Framework for Measuring Inflation and Economic Conditions

1. Expand the Scope of Key Indices

• Reinstate previously excluded categories such as mortgage costs and car payments to reflect real financial burdens.
• Introduce the cost of borrowing (e.g., interest on loans, credit cards) as a core element of inflation metrics, particularly given the significant impact of interest rate hikes.
• Consider also factoring in the cost of funding one's retirement.

2. Adjust Weighting Based on Frequency and Impact

• Modify inflation measures to account for the frequency and financial weight of different categories in household budgets. Essential recurring costs like healthcare, childcare, and housing should be given higher weight compared to discretionary or infrequent costs like electronics.

3. Introduce Income-Expense Affordability Metrics

• Develop an “Affordability Index” that:
  • Measures typical non-negotiable living expenses (e.g., housing, food, healthcare, transportation), savings and retirement needs, and discretionary expenditures.
  • Maps these expenses against different levels of after-tax income.
  • Highlights the percentage of the population earning sufficient income to cover these costs versus those falling short.

4. Tiered Population Insights

• Categorize income levels into tiers and show how each tier corresponds to financial adequacy for:
  • Living expenses
  • Healthcare costs
  • Savings and retirement contributions
  • Reasonable discretionary spending
• Identify the percentage of the population in each tier and highlight gaps in financial adequacy.

5. Translate Findings into Forward-Looking Insights

• Use affordability data to forecast potential societal impacts, including:
  • Public health crises due to unmet healthcare needs.
  • Housing market trends based on affordability gaps.
  • Poverty levels and income inequality trends.
  • Potential for societal unrest or instability linked to economic pressures.

6. Enhance Transparency and Public Trust

• Publish detailed explanations of how inflation metrics are calculated, including the rationale for included and excluded components.
• Engage independent organizations to audit inflation measures and provide unbiased recommendations.

Implementation Plan

1. Stakeholder Collaboration: Partner with the Bureau of Labor Statistics (BLS), Federal Reserve, academic institutions, and public health organizations to redesign inflation measures.
2. Data Collection and Modeling: Collect data on household budgets across income levels and test the new indices on historical and current economic scenarios.
3. Legislative Action: Advocate for policy changes to adopt new metrics in Social Security adjustments, tax brackets, and Federal Reserve decision-making.
4. Public Education Campaign: Inform the public about the updated measures and their implications for economic planning.

Anticipated Benefits

1. Improved Accuracy: A comprehensive approach will better represent the financial realities of households across income levels.
2. Policy Alignment: Policymakers will gain clearer insights into economic conditions, allowing for more targeted and effective interventions.
3. Economic Equity: Highlighting income disparities and affordability gaps will help ensure monetary and fiscal policies address the needs of underserved populations.
4. Proactive Planning: Forward-looking insights will enable policymakers to anticipate and mitigate risks such as public health crises, housing market instability, and societal unrest.

Conclusion

Redesigning inflation and economic measures to include affordability metrics, connect income to expenses, and provide forward-looking societal insights will enable better decision-making for policymakers and households. This is a crucial part of how we could design and deliver a better citizen experience. Such a comprehensive approach will foster economic equity, build public trust in official statistics, and ensure a more sustainable and inclusive economic future. And maybe - just maybe - prevent future election surprises.