Inflation is 1.6%: So Let’s Tighten

New CPI numbers are out this morning with headline CPI coming in at 1.8% and core CPI at just 1.6%. The Fed generally uses core CPI (which excludes food and energy prices) when it makes monetary policy as it is less volatile and more indicative of long-run inflation. Last month’s core CPI was 0.2% as was this month’s. On a year-over-year basis, the indicator fell from 1.7% in May to its current 1.6%. Yet, what have markets spent the last month talking about? When the Fed will start to tighten.

This continues to make no sense and has not made any sense for years now.

The Fed has a goal of 2% inflation. When inflation is less than that 2%, the Fed should instill looser monetary policy to raise it. When inflation is below 2% and unemployment is high, this should be a no-brainer. At the very very least, it shouldn’t be talking about when it will instill tighter monetary policy.

If the Fed were really sticking to its goal of 2% inflation, it would overshoot and undershoot it a relatively equal amount as it attempted to hit that target exactly. Instead, the Fed has consistently undershot its goal. Inflation has been below 2% for years now. Meanwhile, unemployment sits at 7.6%. There’s a real human and economic cost to the Fed’s persistent committment to undershooting its 2% target. Its talk over the past month of tapering has already raised mortgage rates. But let’s continue to talk about tightening with inflation coming in under target. That makes perfect sense.

CPI Is A Technical Fix, Let’s Keep It That Way

President Obama unveiled his budget yesterday and liberal groups have responded angrily to the inclusion of Chained-CPI in the proposal. A quick recap: currently Social Security benefits increase each year to keep pace with inflation according to the Consumer Price Index (CPI). The current calculation for inflation does not take into account that when the price of one product increases, people will switch to a lower-priced substitute instead of paying the higher price. The classic example is that when the price of beef rises, people buy more chicken and less meat, so the actual increase in the cost-of-living is not equal to the rise in the price of meat. Chained-CPI takes this into account. Since Chained-CPI is a low measure of inflation, Social Security benefits will grow at a slower rate. Thus, liberals argue that Chained-CPI is a benefit cut.

However, both CPI and chained-CPI estimate inflation for the average person. But Social Security beneficiaries are not average people. Most of them are elderly and much of their consumption comes in the form of health care and housing. Since health care and housing prices have risen faster than the rest of economy, the cost-of-living for seniors has increased at a quicker rate as well. That means that CPI and Chained-CPI both actually underestimate inflation for Social Security beneficiaries. Their benefits should actually rise quicker than inflation.

Nevertheless, much of the discussion right now centers on the fact that Chained-CPI is a benefit cut. The Washington Post‘s Dylan Matthews outlines everything I’ve said above and more, but finishes his piece by saying:

But ultimately, the question of which you prefer likely has more to do with whether you think Social Security benefits need to be pared back to ensure the program’s long-run solvency, or whether you think the elderly need, if anything, a benefit bump. Those are policy questions, not technical ones, and all the debate in the world about chained CPIs and CPI-Es relative methodological merits won’t resolve them.

Slate’s Matt Yglesias has a slightly better take:

As a technical matter, the best way to express this would be to start with the most accurate possible measurement of the price level (I might prefer the PCE deflator) and then inflate it by a fixed amount. But using a measurement of the price level that slightly overstates inflation works too.

If we want to have real benefits increases slowly each year for beneficiaries, then let’s use Yglesias’s technical fix. But, let’s start by getting the level of inflation right. CPI is not correct. Chained-CPI is also not correct. The closest measure right now may be CPI-E, but it’s still experimental and not ready for use.

In the end, I’m with Kevin Drum: let’s budget a small bit of money to research and develop a precise measure of inflation and then implement it. After that, we can start talking about inflating it by a fixed amount (as Yglesias advocates) or pairing benefits back altogether (as many Republicans advocate). First, though, let’s get it right.

Switching to Chained-CPI and How Politicians Spin it

I’m getting a bit annoyed at the liberal blogosphere about how they’re spinning the proposal to use chained-CPI for Social Security. Here’s Ezra Klein:

The way we measure inflation right now really does mismeasure inflation. Chained-CPI really is a bit more accurate. But that’s not why we’re considering moving to chained-CPI. If all we wanted to do was correct the technical problem, we could make the correction and then compensate the losers.

But no one ever considers that. The only reason we’re considering moving to chained-CPI because it saves money, and it saves money by cutting Social Security benefits and raising taxes, and it’s a much more regressive approach to cutting Social Security benefits and raising taxes than some of the other options on the table.

The question worth asking, then, is if we want to cut Social Security benefits, why are we talking about chained-CPI, rather than some other approach to cutting benefits that’s perhaps more equitable? The answer is that chained-CPI’s role in correcting inflation measurement error is helpful in distracting people from its role in cutting Social Security benefits. Politicians who are unwilling or unable to offer a persuasive political or policy rationale for cutting Social Security benefits are instead hiding behind a technocratic rationale. We’re not “cutting benefits,” we’re “correcting our inflation measure.”

Emphasis mine. I sympathize with Ezra’s annoyance here. Switching to chained-CPI is being billed as a “technical fix.” If we wanted to implement such a technical fix, we don’t need it to be part of a grand bargain. Social Security benefits should increase with inflation. If we’re using the wrong measure of inflation, then we need to fix that. The reason Republicans are so set on fixing it now is because their ultimate goal is to cut benefits, not to correct the inflation measure. Thus, Ezra’s right when he says:

We’re not “cutting benefits,” we’re “correcting our inflation measure.”

However, Ezra makes the exact same error in the bolded section above. Continue reading “Switching to Chained-CPI and How Politicians Spin it”