Interest payments aren’t counted in the inflation rate. This is a fact that a lot of readers find confusing, if not angering, especially now, when rates are high on mortgages, auto loans and credit cards. I get lots of mail from people saying the absence of interest rates from the Consumer Price Index seems like sleight of hand by the government, the economics profession or both.
So I probably won’t win a lot of friends by saying that I think the way the government economists do things is correct. But when they’re right, they’re right.
I’ll grant that higher interest payments do feel just as inflationary as higher prices for ice cream, bowling balls and haircuts. People hate paying more interest. Dissatisfaction with high interest rates and the unavailability of consumer credit explains why consumer sentiment is worse than would be expected given current levels of inflation and unemployment, Lawrence Summers, the former Treasury secretary and Harvard president, wrote in February in a working paper with three other economists.
There is, they wrote, “a disconnect between the measures favored by economists and the effective costs borne by consumers.” Their paper was titled, “The Cost of Money is Part of the Cost of Living: New Evidence on the Consumer Sentiment Anomaly.” Inflation would have hit 18 percent in 2022 if the government had calculated it the way it did before 1983, including mortgage rates, they found.
You might be surprised, then, that Summers is not arguing for the Bureau of Labor Statistics to put interest rates in the Consumer Price Index. “I don’t think the purpose of the C.P.I. is to predict people’s sentiment,” he told me this week. “The purpose is to measure the cost of goods and services.”
Summers added: “I’m very reluctant to criticize the B.L.S. concepts or suggest alternatives. The correct statement from our paper is, ‘You cannot assume from a low C.P.I. that consumers are feeling that life is affordable.’”
The economic logic of leaving interest payments out is that interest on loans is conceptually different from payments for the goods and services that are counted in inflation, such as food, clothing and shelter. Interest payments aren’t payments for consumption, so they have no business being included in indexes of consumer prices such as the Consumer Price Index and its cousin, the Personal Consumption Expenditures price index.
What is interest, then, if not payment for consumption? It’s the price to shift the timing of consumption. You consume extra now using borrowed money, and consequently consume a little less in the future because some of your income has to go toward paying off the loan. Ideally you are richer in the future, so your future, richer self is supporting the lifestyle of your current, poorer self. Whether that’s the case or not, borrowing is a financial maneuver that’s fundamentally different from, say, buying an ice cream cone.
I get that interest payments are a real expense. But what about the opposite, interest receipts — say, on a saving account, a certificate of deposit or a bond you own? It would be inconsistent to count rising interest payments in the cost of living without somehow subtracting rising receipts. You can see how that would get messy.
Mortgage interest was included in the Consumer Price Index up until 1983, and it really did get messy. The Bureau of Labor Statistics measured housing costs through a complex formula that included sales prices, mortgage rates, property taxes, insurance and maintenance costs. Bureau officials called the approach “very ad hoc.”
As I wrote last year:
One problem they identified was that the bureau’s measure didn’t distinguish between a house as an investment and a house as something a person “consumes,” or uses for shelter. If you rent and your rent goes up, that’s just plain bad. But if you own and the price of your house goes up, that’s kind of good. Because a house is partly an investment, the interest you pay to buy it can be thought of like the interest you pay on a margin loan to buy shares of stock.
There were also problems with collecting reliable and comparable data on mortgage rates and house prices.
The new way to think about the cost of homeownership is conceptually cleaner. The logic is that if you own a house, you have the option to rent it out. So the cost to you of living in your home is the rental income you forego by not renting it out (the “opportunity cost,” in econ lingo). Then it’s a matter of calculating what a house like yours would rent for.
Interest rates do affect the C.P.I. indirectly by affecting the rental rates that go into the C.P.I. If the cost of owning a home goes up because of rising interest rates, that will push up rents as well, because more people will choose to keep renting. Plus, owners of apartment buildings will want to charge higher rents because alternative investments, such as Treasury bonds, become more lucrative when interest rates go up.
This is not just an ivory tower theory. People who are trying to decide whether to switch from renting to buying are constantly comparing costs.
In practice, it’s not always easy to figure out what a house would rent for if there aren’t others like it in the area. That’s mostly a problem for high-end properties. But the rental-equivalence approach does zero in on the cost of the service that housing provides, which makes housing more directly comparable to, say, hairdressing or a lawyer’s time.
Here’s an example of the superiority of the new approach: House prices and rents should roughly move up and down together, since they compete with each other in the market for housing services. Let’s say house prices go up but rents don’t. That’s probably because of speculation on houses as assets. Asset inflation — whether of houses or stocks and bonds — should be excluded from the C.P.I.
If you think of the C.P.I. as measuring the overall cost of living, rather than a particular basket of goods and services, the idea of somehow including interest payments does make some sense. When interest rates get higher, it makes it more expensive to smooth consumption over time. That’s just a fact.
For now, though, Steve Reed, a B.L.S. economist, told me, interest payments are “still technically out of scope” for the C.P.I. I hope more readers can now see why — although I also see why so many think that’s crazy.
The Readers Write
If Israel’s economy is as strong as some believe, why is the U.S.A. still sending aid, including munitions?
Caryl Mlincek
Rock Hill, S.C.
You posited that employers “need to give workers better tools and more training.” I completely agree with the training part of your position. However, as a store-level employee of Whole Foods Market for nine years, experiencing life before and after being Amazoned, I can assure you that in many cases, providing “better tools” is merely a euphemism for implementing technology to replace human workers up and down the supply chain.
Jonathan Drew
Mansfield, Mass.
If a firm’s production of widgets goes from 10,000 to 12,000 in a year, is that solely because of the smarty pants at the top?
Andrew Levine
Hamilton, Ontario
The push for pay equity over the years could have easily raised the wages of women and nonwhite folks to that of their white male peers, rather than depressing the wages of the white men to match those of everyone else.
Alison Tatum
Chicago
Regarding your choice of Elinor Ostrom for the Quote of the Day: She understood, as a political scientist, that efficiency was only one of the criteria by which we could judge allocation mechanisms. She was a great economist precisely because she wasn’t “really” an economist.
Nathan Paxton
Washington
Quote of the Day
“It is stupid to claim that birds are better than frogs because they see farther, or that frogs are better than birds because they see deeper. The world of mathematics is both broad and deep, and we need birds and frogs working together to explore it.”
— Freeman Dyson, Notices of the American Mathematical Society (February 2009)
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