Submitted by Joseph Carson, Former Director of Global Economic Research, Alliance Bernstein.
Inflation has often been involved in political controversy, but today the pendulum has swung from politicians to monetary policymakers. Politicians used the controversy over high inflation to force change in its measurement. Monetary policymakers are using the controversy over low inflation to force change in its policy guidance.
As monetary policymakers have become enmeshed in the politics of the numbers it is important to understand how the politics of inflation has shaped its measurement. Inflation for politicians is to be as low as possible, while inflation for policymakers is to be as accurate as possible. Those two are not always the same, and policymakers mistook it to be true during the housing boom and failed to recognize market price signals. Are policymakers risking making the same mistake again?
This is not the place for a detailed discussion on inflation indexes but suffice it to say there are two basic methods, a "cost of things" and a "cost of living" framework, with variations around each of them. The relationship between the two methods is not constant since "cost of living" is more of an academic concept and not based fully on market prices.
The politics of inflation often involved discussions over which approach to employ for the indexation of social programs, and politicians often favored whatever approach yielded low inflation.
For example, in the early 1980s, consumer inflation (CPI), based on the "costs of things" framework, was driving up the federal government costs of indexation for social programs and the controversy over measurement provided Congress a convenient format to use its statistical policy-making role to force change, while also trying to reduce the budget deficit. The controversy ended with Congress endorsing its first shift towards a "cost of living" framework as it recommended removing actual house prices and replaced them with a subjective measure of owner’s rents.
The politics of inflation erupted again in the mid-1990s when Federal Reserve Chairman Alan Greenspan told Congress the current measure of inflation was over-stating actual inflation by a full percentage point, costing the federal government billions in its indexation of government social programs. Congress demanded immediate action, with one piece of legislation going as far as holding back on appropriations for the government statistical agencies until it lowered the inflation index.
In the end, Congress established a panel of outside experts to study the controversy. The group of experts recommended the inflation index should be designed more like a "cost of living" index and made a number of recommendations, all of which would result in lowering inflation and overlooked any changes that would lift the index. Soon after, with Congress insistence government statisticians started to implement various statistical changes in measurement, moving the inflation index one large step closer to the concept of "cost of living".
The politics of inflation demonstrated how politicians have used their political clout to lower reported inflation. While there were legitimate issues of concept and design involved in both debates, political opinion was mainly shaped by the dollars to be saved at the federal government level if the inflation index were to increase more slowly.
The controversy converted the inflation index from a "cost of things" to a "cost of living" index. However, in reality, today’s inflation index is not a true "cost of living" index as it’s missing important items, such as financial assets. So, in practice, the inflation index is mishmash, or a hybrid, as it includes actual prices with "imputed" prices.
A hybrid inflation index is not appropriate for monetary policy as the focus needs be on the actual "cost of things." And targeting a hybrid index becomes a problem when there is a great variance between actual prices and imputed prices as evident in the 2000s when house prices skyrocketed and "imputed" rents hardly moved. That trend is also present today but on a smaller scale, suggesting the "cost of things" has been moving up at a faster rate compared to the "cost of living".
Policymakers should borrow a page from the politicians playbook and conduct a study of price measurement to ensure today’s measures meets their purpose of economy wide inflation. It would also be wise to examine why asset price cycles have been much greater since the shift towards a "cost of living" index and numerical price targeting. Politics of inflation should never favor one type over another as history has clearly shown easy money creating or promoting inflation in only two areas (real and financial assets) can be just as bad economically and financially as if it shows up in all of the items.