Interest payments don't count toward the inflation rate. This is a fact that confuses and infuriates many readers at a time when interest rates on mortgages, car loans, and credit cards are so high. I've received many emails from readers who say that the lack of interest in the Consumer Price Index seems like a ploy by governments, economists, or both.
So I probably won't win many friends if I say I think the government economists are right, but when they're right, they're right.
Indeed, rising interest rates feel as inflationary as rising prices for ice cream, bowling balls or haircuts. People don't like rising interest rates. Frustration over high interest rates and a shortage of consumer credit is why consumer sentiment is weaker than expected given current levels of inflation and unemployment, former Treasury Secretary and Harvard University President Lawrence Summers wrote in February in a working paper he co-authored with three other economists.
“There is a disconnect between the measures economists favor and the actual costs borne by consumers,” they wrote in their paper, titled “The Cost of Money is Part of the Cost of Living: New Evidence of Anomalies in Consumer Confidence.” They found that if the government had included mortgage interest rates and calculated inflation the same way it did before 1983, inflation would have reached 18% in 2022.
You might be surprised that Summers hasn't urged the Bureau of Labor Statistics to incorporate interest rates into the Consumer Price Index. “I don't think the purpose of the Consumer Price Index is to predict people's feelings,” he told me this week. “The purpose is to measure the cost of goods and services.”
Summers added: “We are reluctant to criticize the BLS concept or propose alternatives. The correct statement in our paper is: 'A low Consumer Price Index does not allow one to infer that consumers perceive the cost of living as affordable.'”
The economic logic for excluding interest payments is that interest on loans is conceptually different from payments for goods and services that do count toward inflation, such as food, clothing, and shelter. Interest payments are not payments on consumption, and therefore should not be included in consumer price indexes such as the Consumer Price Index and its cousin, the Personal Consumption Expenditures Price Index.
So what is interest if not a payment for consumption? It is the price of shifting the timing of consumption. If you consume more now using debt, you end up consuming a little less in the future because you have to put some of your income towards paying off the loan. Ideally, you will be richer in the future, and your richer future self will support the lifestyle of your poorer present self. Whether or not that is the case, debt is a fundamentally different financial operation from, say, buying ice cream.
I understand that interest payments are a real expense. But what about the opposite – the interest income from a savings account, a fixed deposit, or bonds that you own? It would be a contradiction to include the increase in your interest payments in your living expenses and not deduct the increase in your income. You can see how that could get complicated.
Mortgage rates were included in the Consumer Price Index until 1983, but in practice, it was confusing. The Bureau of Labor Statistics measured the cost of housing using a complex formula that included sales price, mortgage interest, property taxes, insurance, and maintenance costs. Bureau of Labor Statistics officials called this method “highly ad hoc.”
As I wrote last year:
One problem they point out is that the bureau's measurement doesn't distinguish between housing as an investment and housing that people “consume,” i.e., use as a residence. If you rent, rising rents are simply a bad thing. But if you own a home, rising home prices are actually a good thing. Because housing is also an investment, you can think of the interest you pay on a home purchase as the same as the interest you pay on credit to buy stocks.
There were also problems collecting reliable and comparable data on mortgage rates and house prices.
The new way of thinking about the costs of homeownership is conceptually clear. The logic is that if you own a home, you have the option of renting it out. So the cost of living in your home is the rental income you forfeit by not renting it out (the “opportunity cost” in economics terms). You then calculate how much it would cost to rent a home like yours.
Interest rates indirectly affect the CPI by influencing rents, which are reflected in the CPI. When rising interest rates increase the cost of homeownership, more people continue to rent, which in turn increases rents. Additionally, apartment owners may want to charge higher rents because rising interest rates make alternative investments, such as government bonds, more attractive.
This isn't just ivory tower theory: People trying to decide whether to switch from renting to buying are comparing costs all the time.
In reality, it's not always easy to calculate how much rent a house would cost if there are no similar houses in the area — this is mainly an issue for luxury properties — but the rent equivalent approach focuses on the cost of the services a house provides, making it more directly comparable to, say, a hairdresser's visit or a lawyer's time.
Here's an example that illustrates the advantages of the new approach: House prices and rents should rise and fall roughly together because they compete with each other in the housing services market. House prices rise but rents do not. This is probably because we are speculating on housing as an asset. Asset inflation, whether it be housing or stocks and bonds, should be excluded from the CPI.
If you think of the CPI as measuring the overall cost of living, rather than a basket of specific goods and services, the idea of ​​including interest payments in some form certainly makes sense: higher interest rates make it more costly to smooth out consumption over time. That's just a fact.
But BLS economist Steve Reed told me that for now interest payments are “still technically outside the CPI.” I hope more readers understand why that is, though I can see why many people find it odd.
Reader comments
If Israel's economy is as strong as some believe, why is the United States still sending aid, including military supplies?
Caryl Mlyncek
Rock Hill, South Carolina
You argued that employers “need to give workers better tools and more training.” I completely agree with the training part of your observation. However, having worked as a store-level employee at Whole Foods Market for nine years and experiencing life before and after Amazonization, I can safely say that in many cases, providing “better tools” is just a euphemism for deploying technology to replace human workers up and down the supply chain.
Jonathan Drew
Mansfield, Massachusetts
If a company increases its part production from 10,000 to 12,000 in one year, is it all down to the smart people at the top?
Andrew Levin
Hamilton, Ontario
Years of pushing for pay equality could have easily raised the wages of women and non-whites to those of white men, rather than lowering white men's wages to match everyone else's.
Allison Tatum
Chicago
On choosing Elinor Ostrom as today's quote: As a political scientist, she understood that efficiency is only one criterion for judging allocative mechanisms. She was a great economist precisely because she was not a “real” economist.
Nathan Paxton
Washington
Quote of the Day
“It is foolish to claim that birds are superior to frogs because they can see farther than birds, or that frogs are superior to birds because they can see deeper than birds. The world of mathematics is large and deep, and birds and frogs need to work together to explore it.”
— Freeman Dyson, Notice of the American Mathematical Society, February 2009
