Viewpoints

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.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in March showed some moderate variance. Four states were down slightly from February. The largest increase was Arizona’s .8 percent; three other states (Iowa, Delaware, and Vermont) had gains of at least .5 percent. Over the three months since December, Massachusetts was up 1.9 percent, while 8 other states (scattered across the nation) rose more than 1 percent. Over the last 12 months, Massachusetts again led, with an increase of 4.9 percent, while New York’s 3.6 percent was a fairly distant second. 5 states were down over the period, with Montana’s slump continuing, with a loss of 3 percent.

The independently estimated national figures of growth over the last 3 months (.75 percent) may be a touch higher than the state estimates would have suggested, but the 12-month figure (2.9) percent) looks to be roughly in line with the state numbers.

State labor markets were little-changed in March, but on the whole the report looked better than February’s. Only five states had statistically significant gains in payrolls (Arkansas, Georgia, Kansas, Kentucky, and Virginia), with two having .5 percent increases (Arkansas and Virginia). The other states, and DC, had insignificant changes, though numbers had point increases comparable to those that were deemed significant. For instance, California had an increase of about 30,000, though that was less than .2 percent, and New Jersey was up around .3 percent.

Six states had statistically significant declines in their unemployment rates in January, while one had a significant increase. The only move larger than .1 percentage point was a decline of .3 percentage point in Arizona. The highest unemployment rates were in California (5.3%), DC (5.2%) and Nevada (5.1%). States with unemployment rates of 4.8% (one point above the national rate)were Illinois, New Jersey, and Washington. Maryland, Minnesota, Nebraska, New Hampshire, North Dakota, South Dakota, Utah, Vermont, and Wyoming had rates of 2.8% or lower, with North Dakota at 2.0%.

Puerto Rico’s unemployment rate moved up to 5.8 percent, while the island’s job count moved up by 2,200.

In an April 16, 2024 Bloomberg News article entitled “What If Fed Rate Hikes Are Actually Sparking US Economic Boom?”, it is argued that the Fed’s increase in the federal funds rate from 0.08% in March 2022 to 5.33% in July 2023, which, in turn, pushed up other interest rates, stimulated US domestic aggregate demand for goods and services by increasing interest income to holders of fixed-income assets. Wow! This novel hypothesis, if valid, turns monetary policy theory on its head.

Let’s look at some data. As can be seen in Chart 1, there does indeed seem to be some positive correlation between the level of the federal funds rate and the level of personal interest income. For example, when the Federal Open Market Committee (FOMC) hiked the federal funds rate from the beginning of 2016 through the first quarter of 2019, personal interest income moved up sympathetically. Although personal interest income had started increasing in 2014, before the FOMC had begun raising the federal funds rate. Similarly, as the FOMC began hiking the federal funds rate in 2022, personal interest income starting rising, too. So far, so good for this hypothesis that FOMC federal funds hikes raise personal interest income.