The apparent disconnect between the state of the US economy and voters’ perceptions of it has puzzled economists for months. Unemployment is low, inflation has come way down and real wages are no longer lagging behind. Yet consumer sentiment is still lower than you’d expect. A new paper offers a concise and persuasive explanation: “Consumers, unlike modern economists, consider the cost of money part of their cost of living.”
The authors are former Treasury Secretary Larry Summers (a paid contributor to Bloomberg TV), Karl Schulz and Judd Cramer of Harvard, and Marijn Bolhuis of the IMF. Summers’ contribution on this topic might raise some eyebrows. His recent record on inflation punditry has been mixed. He was right early on about the pressure of excess demand and the need to curb it; his characteristically confident judgment that unemployment would need to rise to get prices back under control has proved wrong (so far). The new paper isn’t punditry but a scholarly effort, and it seems to solve a mystery. Like most good answers, however, it raises further questions.
By now there’s quite a literature on “The economy is doing just great so why haven’t people caught on?” Economists are especially perplexed because they’ve long paid attention to the “misery index” – the inflation rate plus the rate of unemployment. This number is currently much lower than its long-term average. Yet consumer sentiment as measured by the University of Michigan’s polling, despite a recent improvement, is also lower than the long-term average. On the face of it, people are being gloomy for no objective reason.
Various explanations have been offered. The idea that people are too stupid to see what’s going on is popular (though usually phrased more politely). But other theories abound. Price increases have been skewed toward the costs of goods and services that loom large in the budgets of lower-income households. The level of prices, as opposed to their rate of increase, matters in its own right for those on fixed nominal incomes or otherwise coping with financial insecurity. Psychology might be a factor: After years of very low inflation had accustomed us to stable prices, we found the spike disproportionately unsettling. Perhaps dismay over America’s broken politics and dysfunctional government has so lowered national spirits that the malaise bled into the consumer-sentiment index. And so on.
The new paper argues that the answer is mostly high interest rates. These aren’t included in the standard measures of inflation, but they affect the cost of living. High mortgage rates raise the cost of owning a home; high car-loan rates make buying a car more expensive; for many consumers, high credit-card rates raise the effective price of goods and services. The paper shows that factoring the cost of borrowing into a suitably adjusted measure of consumer prices explains three-quarters of the apparent sentiment gap.
You might be wondering why the CPI and other measures of inflation don’t include borrowing costs in the first place. Good question. It isn’t crazy to think of credit as a service for sale at a price, much like other services. And interest costs do sneak into the standard measures here and there. For instance, the car-leasing element of the CPI includes an interest-charge component. But for the most part interest costs are excluded, mainly because measuring inflation is hard to begin with, and trying to add in borrowing costs makes it even harder.
Housing is a particular challenge because owning a house is both an investment and (arguably) a form of consumer spending: Owner-occupiers are consuming a service, namely shelter. Before 1983, the CPI included an estimate of owners’ housing inflation that took account of mortgage rates alongside house prices and other costs – in effect, merging the investment and consumption components. This theoretically muddled treatment was judged to overstate inflation, so since 1983 inflation in the cost of home ownership has been measured in terms of “owners’ equivalent rent” – what the owner would have to pay to rent the house. This approach focuses attention on the consumption part of home ownership. But concentrating on OER also removes mortgage rates from the calculation, which sidelines a crucial component of the perceived cost of living.
The treatment of housing is difficult for other reasons too. OER accounts for about a quarter of the CPI basket and even more of so-called core CPI. Yet it’s the cost of a hypothetical purchase, not a real one. As the Cato Institute’s Alan Reynolds points out, it “purports to measure monthly variations in a price nobody pays.” Also, it introduces lags into estimated inflation, artificially suppressing it through mid-2022, as Reynolds shows, and significantly overstating it since then. The standard treatment in the European Union is simply to exclude OER from the calculations. If the US measured inflation the EU way, the CPI would have risen 2.3% in the year to January, not 3.1%.
Summing up, if the cost of living was measured more accurately by including interest costs, “inflation” would be higher, and the sentiment gap would be largely explained. Alternatively, if the cost of living was measured more accurately by excluding owners’ housing costs – a possibility that the paper doesn’t go into – “inflation” would be lower, and the sentiment gap would be bigger still.
Evidently, defining inflation – let alone measuring it – isn’t easy. The cost of living is in the eye of the beholder, and different households face very different inflation rates. Any one measure can miss the point, especially when extraordinary pressures (pandemics, wars) disrupt settled economic patterns. So if people say they’re gloomy about the economy, don’t be too quick to dismiss their assessment.
Something else is also worth considering. Whether or not interest costs belong in measures of inflation, they certainly affect perceptions of the cost of living. When the Federal Reserve raises interest rates to suppress demand, it’s making a lot of households worse off. Sometimes that’s necessary, but it’s never easy. Many economists think running the economy hot is good policy because any uptick in prices can be dealt with promptly and painlessly. Not always.
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