Over the past several decades, the methods of measuring inflation has changed significantly, frequently shaped by political influences and policymakers. These changes, particularly the deliberate exclusion of financing costs, have produced a lower and less volatile index. It is reasonable to assert that the preferential treatment of finance in price measurement has contributed to the substantial expansion of finance and asset markets over the past fifty years.
Inflation Politics That Favored Finance
In 1981, the Bureau of Labor Statistics (BLS) announced that the CPI would no longer measure housing costs based on house prices and mortgage interest costs. The BLS justified this change by stating that new types of mortgage instruments with variable rates and shorter financing terms had emerged, making the standard, long-term, fixed-rate mortgage no longer representative of the mortgage market. However, there was also a political aspect. In 1981, Congress passed legislation mandating the use of the CPI to adjust individual income tax brackets, leading politicians to support any modification that would result in a lower index.
In the mid-1990s, Federal Reserve Chairman Alan Greenspan told Congress that the CPI overstated the cost of living and suggested decreasing the CPI by one percentage point when adjusting federal government entitlement programs. Greenspan did not offer any hard evidence of his estimate, nor did he mention that the CPI is a price index, not a cost-of-living index. Despite this, his remarks sparked a fierce political debate that eventually lead Congress to demand the BLS produce a lower index.
Congress soon conducted hearings regarding the possibility that the CPI might be overstating inflation and established an Advisory Commission, led by Michael Boskin, to examine the matter. The Boskin commission concentrated on strategies to produce a lower index and largely overlooked factors that could result in a higher one.
In 1998, the BLS implemented several modifications to the CPI measurement, some of which were advantageous to the finance industry. For example, the BLS excluded new car loans from the CPI calculation, thereby further distancing finance from inflation measurement. Also, BLS ended its separate survey of owner-occupied homes to assist in estimating rent changes for primary residences. BLS claimed it faced estimation issues due to an inadequate sample of owner-occupied homes available for rent. Consequently, the BLS linked owner-occupied rental rates to the rents of typical rental units.
This change, along with the one in 1981, helped prevent an even larger downward adjustment in finance and asset markets during the tech bubble. This was because, over the following years, the sales prices of existing homes soared, while rents remained stagnant. Stephen Cecchetti, a Professor of International Finance at Brandeis University, estimated that both headline and core consumer price inflation would have risen by 4%, nearly double what was reported during the housing bubble (2000-06), if the BLS had not excluded the cost of financing and home prices from the CPI. He concluded, "Had these been the inflation readings, it’s hard to imagine the Fed keeping their federal funds rate target below 2% for three years."
In the early 2000s, Fed policymakers were contemplating the adoption of a price target rule. There was a discussion about whether the CPI or the PCE should be the preferred target index. The Fed transcripts indicate that Federal Reserve Chairman Alan Greenspan favored the PCE's weighting structure over the CPI due to its smaller weight for housing. Mr. Greenspan ignored or intentionally overlooked the fact that 30% of the PCE consisted of items not paid by consumers, much of which are based on imputed and non-market prices, far surpassing the 23% housing weight in the CPI. Ultimately, Mr. Greenspan succeeded in convincing other policymakers to pick the PCE, which provided the Fed with a lower index for the price stability mandate.
The impact on reported consumer price inflation from omitting the cost of financing/money has never been more evident than in recent years. Research by a group of economists from Harvard University and the International Monetary Fund indicates that if measurement changes excluding financing costs and house prices had not taken place, reported inflation would have been two to three times higher (i.e., in the mid-teens) than what was published during the period 2021 to 2023.
The new administration is heavily influenced by finance professionals, meaning there will be no motivation to alter how inflation is measured. Additionally, the Federal Reserve is closely aligned with financial markets, which also means there will be no drive to modify price measurements. A new measurement approach will only be considered if another financial crisis occurs, prompting politicians, policymakers, and analysts to agree that price measurement should more comprehensively include financing costs.