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Semi-retired blogger Scott Sumner commented on Karl’s post about how the CPI calcuates inflation of owner-occupied housing. So long as he keeps commenting around the econ blogosphere, we can effectively keep him from retirement by hoisting these comments. Here is Scott on Angus, to whom Karl was responding:

I read his argument differently. Reading between the lines, here’s what I think he meant:

1. The Fed doesn’t care about the “cost of living” per se, they care about the price level because supposedly a stable price level produces macroeconomic stability.

2. The price of new homes is an important part of the overall price of goods and services produced in the US.

3. If the Fed stabilizes a price index, that index should include the price of new homes.

4. It’s fine if we have a cost of living index that excludes the price of new homes, just don’t have the Fed target that index.

I don’t see your argument as being inconsistent with what he wrote.

I think Scott’s point here is that there’s a distinction between what should go in a cost-of-living index and what the Fed should target. I’m pretty skeptical of this idea, so I’ll run through some reasons why.

One conceptual problem is that house prices reflect value of the flow of housing services consumed and the investment value of the home. As Karl points out, why should housing investments be counted in a cost-of-living index while other investments are excluded?

A 2005 survey of OECD countries found that 13 out of 31 statistical agencies used the owners-equivalent method for their CPI, and the next most popular method, used by 9, was to just leave owner-occupied housing out. Only two countries, Australia and New Zealand, utilize the acquisition approach, which measures house prices changes the same way you would with non-durable goods. Below is a graph from The Economist of the ratio of house prices to rents from Q1 2000 to Q4 2010 for Australia, the U.S., and New Zealand (the United States is the lowest one at the end, it’s a little hard to tell with the colors).

While the other two countries have thus far avoided a massive crash, they didn’t avoid massive appreciation. You could argue that this just means the changes in prices in these two countries was real and driven by fundamentals. But given these massive differences in the real paths of price-to-rent ratios, what level should the Fed target?  How do they distinguish price appreciation drive by real changes in cap rates from pure nominal or speculative inflation? I’m not sure how Australia and New Zealand handle this.

Another problem with the acquisitions approach is that the sale of a home is frequently an exchange between households, and so a sold house is both a cost and a revenue for the household sector. According to the BLS, when statistical agencies use the acquisitions approach they control for this by only looking at home sales to the household sector from other sectors. In practice, this usually amounts to new housing units. This may reflect the cost of new goods and services produced in the U.S., but clearly doesn’t represent a measure of the cost of goods and services being consumed by households. How would the Fed weigh the tradeoff between a price measure that was a true COLI and one that included houses? Say demographics or something else permanentely shifts average cap rates down and thus real house prices up while the cost of living is unchanged. If the Fed tries to tamp the house price inclusive price index down won’t inflation and thus nominal GDP be too low? Of all people I’d expect Scott to worry about this.

Let me end by saying that I am pretty skeptical about the inclusion of house prices as a component of a cost-of-living index. I’m also skeptical about the idea that the Fed should target a non-COLI price level that includes house prices, but less so than in the former, and I’m not strictly closed to the idea.

Let me try to rephrase me previous post to make the point more clearly, and -taking off my William Jennings Bryan hat- with less populist righteousness.  Cost-of-living measures attempt to look at quality adjusted price changes. When the rents in a given city increase, the housing portion of the CPI goes up and by that measure so has the cost of living. But this increase can simply reflect the positive amenity value of the city going up; less crime, better parks, etc. If you really wanted to do quality-controlled measure of cost-of-living you would control for the fact that higher priced cities reflect higher amenity values.

So when people say well $250k isn’t a lot when you look at the cost of living in that area, that higher cost of living does not reflect complete controls for quality but in fact measures the higher amenity value of the city. This is just consuming a better, and so more expensive good.

In a blog post today, Paul Krugman outlines a hypothetical situation that we could find ourselves in:

And this raises the specter what I think of as the price stability trap: suppose that it’s early 2012, the US unemployment rate is around 10 percent, and core inflation is running at 0.3 percent. The Fed should be moving heaven and earth to do something about the economy — but what you see instead is many people at the Fed, especially at the regional banks, saying “Look, we don’t have actual deflation, or anyway not much, so we’re achieving price stability. What’s the problem?”

I wonder if, on a particularly lazy day when Paul Krugman finds it difficult walk upstairs, he claims that he is in the “main floor trap”? But I digress. There is only one culprit in this situation: the dual mandate.

I’m not an expert on the history of the dual mandate, but I would venture a guess that it was the result of a grand bargain in which “price stability” came from the “hawkish” right, and “unemployment” came from the “dovish” left. The nature of the Fed’s dual mandate is such that it allows the central bank to wiggle out of nearly any situation if finds itself in with little consequence. Since the Fed is aiming at two diametrically opposed targets at once (price stability and full employment), it has large discretion upon which it can draw to justify its policy actions.

Is unemployment 9.5% with core CPI inflation falling below 1% and future expected inflation well below target as well? Well, that’s price stability!

How about persistent inflation rates bordering on double-digits while employment booms? Pat yourselves on the back guys!

In reality, and much to the chagrin of leftists everywhere, the modern Fed (1980’s+) has mostly erred on the side of price stability, which in the recent context has meant 5% NGDP growth with a rough average of 3% real growth and 2% inflation. This has allowed for a NAIRU of around 4-5% for the United States as a whole. Of course, that is a rate…and as long as the unemployed are continually in flux — that is, as long as hires outpaces quits and fires — that rate isn’t much of a problem. What is a problem is that the same dual mandate that was praised by some economists during the Great Moderation is now enabling the Fed to shirk its duties (and perhaps even worse, providing cover for “leveling down” with an implicit policy of opportunistic deflation…which is what Krugman implies above).

The Federal Reserve’s mandate is unique in the world. Most other central banks operate under a “hierarchical mandate” which generally stipulates an inflation target. It is hierarchical, because the central bank can set any target other targets it wants, and pursue them in order as long as they have hit their mandated target. The results of this kind of target vary from country to country.

In my opinion, Congress should scrap the Fed’s dual mandate, and instead mandate that the Federal Reserve set an explicit nominal target, and do everything in their power to hit that target (level targeting). If they’re feeling generous, they can give the Fed discretion as to which target they would like to set. If not, I would specify NGDP. I don’t think that the monetary policymaking body of the Federal Reserve should even look at a single unemployment number. They should focus like a laser on their keeping their nominal target in a very narrow range and leave the question of unemployment (which is a real variable) to other policymakers.

Stabilize monetary policy around a nominal aggregate, and I would wager that unemployment would find a way to work itself out with minimal intervention.


P.S. I kind of smile when I think about the Fed “moving heaven and earth to do something about the economy”. I suppose that is because 1) I think that monetary policy can do so and 2) I’m a huge nerd.

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