Practical analysis for investment professionals
12 March 2018

Why Isn’t There Any Inflation?

Ten years have passed since the global financial crisis. The world economy has recovered, yet we still have not emerged from the most aggressive monetary policy regime ever implemented.

The US Federal Reserve has only recently begun to hike interest rates, and its plans to unwind the trillions of dollars of private mortgages sitting on the public balance sheet are still up in the air.

Source: US Federal Reserve data

When should the Fed take its foot off the pedal? This question rests at the center of a longstanding policy debate between the monetary hawks and doves. Both agree that when policy becomes too accommodative and no real output can be gained from top-down intervention, the market-wide prices of investments, goods, and services increase. The effect is inflation. And while a small, constant rate of inflation is generally considered healthy, large and volatile jumps can be devastating to an economy.

To maintain its dual mandate of full employment and stable prices, the Fed should, therefore, begin raising interest rates once inflation accelerates.

Oddly, published estimates suggest inflation has been nonexistent despite extended, near-zero interest rates and a near doubling of the M2 private money supply since the recession.

Why? Because changes to the measurement methodology of inflation in 1983 have led to the persistent understating of real rising price levels for the median household, thereby clouding the Fed’s policy decisions.

Latent inflation has caused broader damage, however, creating a substantial loss of income for those whose pay is directly linked to published inflation estimates — pensioners, social security beneficiaries, and wage laborers, in particular.

Estimating CPI, A Proxy for Inflation

The most widely used proxy for inflation is the consumer price index (CPI). The US Bureau of Labor Statistics (BLS) publishes a monthly estimate of the annualized increase in prices. This CPI measurement and the estimate of the unemployment rate are two primary signals that guide the Fed’s monetary policy decisions.

The BLS conducts large-sample polling to estimate a basket of goods and services consumed by a representative household. The prices paid for items in the basket are then tracked over time. A value-weighted average price of this basket is a function of both the change in prices and the basket’s composition. The CPI indexes the value-weighted average price changes.

The calculated inflation rate is highly sensitive to both basket composition and the integrity of price estimates. Improving the price signal is only a matter of larger-scale sampling and robust aggregation, while constructing the representative basket is subjective. Judgments are made to determine which expenditures are staples and which are discretionary, luxurious, or investment related. Some expenses are easily labeled, but others, like housing, are not so straightforward.

Is a home a staple household expenditure?

In 1983, the BLS implemented a consequential shift in methodology. The BLS submitted that a home purchase was no longer a staple expenditure, that only rental costs or owner-equivalent rents, say the rent a homeowner estimates they would pay to live in their own home, should be included in the CPI computation.

Prior to this change, homeownership was considered the norm and home-price appreciation was a large component of CPI because most households in the United States are owner-occupied and, therefore, very sensitive to home price appreciation. Since rent growth has been much lower and less volatile than home price appreciation, the CPI currently understates this sensitivity.

Pensions, social security payments, union wages, and other inflation-linked incomes have subsequently remained low compared to substantial run-ups in home prices. The term “asset inflation” emerged to account for this bifurcation.

US Inflation Rate

Source: US Bureau of Labor Statistics (BLS)

Since the 2008 crisis, US homeownership rates have steadily declined to 50-year historical lows. The prices of homes, along with other investments, have doubled, while the median household income has stagnated.

The stock of housing is flowing into the hands of fewer wealthy landlords who have the capital to take advantage of the current low mortgage rate environment. Despite this troubling trend, 64% of homes are still owner-occupied, so including home prices in the representative basket seems appropriate.

Percent of Owner-Occupied Homes

Source: St. Louis FRED

Has the Fed always been so dovish?

The Fed’s policy strategy evolved substantially over the past 40 years. In the 1970 and 1980s, Paul Volcker sparked a recession by setting the effective Fed rate as high as 19% as part of his hawkish campaign to curb massive post-war inflation, which peaked at 14% a year. At the time, Volcker’s decision was unpopular, but with a good deal of hindsight, history has honored his stoicism.

Ever since, Fed leadership has been “dovish,” accommodative, and popular. Interest rates have decreased and the money supply has multiplied. These policies also coincided with massive economic bubbles, their subsequent collapses, and the 2001 and 2008 recessions.

Nowadays, econometric models guide the hand of the Fed and policy decisions are increasingly algorithmic and data driven. Modern economic doctrine, the Phillips Curve system, and the NAIRU (non-accelerating inflation rate of unemployment) define a clear trade-off between unemployment and inflation. Given an inflation target and unemployment tolerance, the Fed’s course of action is mechanical, seemingly dampening the risk of political interference.

Hidden behind model confidence, however, is an amplified risk of measurement error. By redefining inflation and biasing it downward, the BLS has allowed the Fed to prolong periods of easy money.

A Way Forward?

The BLS’s estimation of household expenditures is an earnest effort to describe the world as it is. But when judgments are made about what should and should not qualify as a basic expenditure, biases emerge. These biases have a real effect on household earnings and economic policy and impact the livelihood of those most vulnerable to rising prices.

Median and Top 5% Household Income

Source: US Bureau of Labor Statistics (BLS)

Perception influences reality. By choosing to view the median household as a renter and not a homeowner, Fed policy promoted decreasing homeownership rates and exacerbated inequality between the middle and upper class.

The consequences of inflation are ubiquitous, making the accurate measurement of CPI critical.

If you liked this post, don’t forget to subscribe to the Enterprising Investor.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ erhui1979

About the Author(s)
Brodie Gay

Brodie Gay is a financial data scientist who combines large computer clusters with state-of-the-art machine learning to price and forecast financial assets. He currently works at Unison Home Ownership Investors where he developed a pricing engine to continuously appraise and forecast the prices of over 100 million unique homes in America. Brodie graduated from UC Berkeley with a bachelor's degree in engineering physics and a master's of financial engineering (MFE) degree. He is a lecturer for Eric Reiner's "Quantitative Methods in Derivatives Pricing" course and teaches graduate-level workshops in machine learning and parallel computing. He worked as a quantitative strategist for Goldman Sachs' financial institutions group where he priced insurance policies and optimized bank balance sheets. Before entering the field of finance, he designed and drafted patents at a boutique IP firm in his hometown of Toronto.

11 thoughts on “Why Isn’t There Any Inflation?”

  1. Good article says:

    There is another reason in addition, which is that the Fed began paying interest on reserves on Oct 2008.. (Sep 2008 was Lehman bankrupcy) This was simultaneous with the beginning of asset purchases.

  2. Aaaaaaaaaaaaa says:

    Thank you, those are valuable insights.

  3. Kirk C. says:

    In the early 80’s, I got my first teller-machine card and would take out a “fast-cash” $30 for a weeks’ wallet money. Now it’s usually $300 for the same things. The government, at best, would admit the cost of living has tripled in the period. Wait until the recent massive increases in the money supply come home to roost.

  4. Brad Case says:

    Brodie, thanks for publishing this thought-provoking piece. I disagree with your analysis: I think the 1983 change made the measurement of inflation more accurate, not less so. My main concern, however, is the opposite of yours: the way that price changes are measured overstates inflation, rather than understating it. Specifically, “inflation” means that the price for a basket of goods OF CONSTANT QUALITY. The BLS does this by specifying a product with specific quality parameters and collecting data on the price of that product. But it’s impossible to do this consistently because quality keeps ramping up, and the BLS is unable to keep up. Regardless of the number of bedrooms, number of bathrooms, etc., houses now have far fewer construction defects than they used to–so part of the increased price of housing reflects higher quality. Cars are much better constructed, much safer, much more fuel efficient now than they used to be–so part of the increased price of cars reflects higher quality. Cell telephone service, computer software, most forms of technology software and hardware are of much higher quality now than just a few years ago. So I suspect that we’re paying much LOWER prices for a basket of goods of the same quality now than we used to.

    1. Brodie Gay says:

      Hey Brad, very sharp point. There is a strong argument that increases in the quality of good and services also bias the estimation of inflation. We address these relatively thoroughly in our white paper on CPI construction ( However, we make the case that items such as energy and housing have such a large loading on the computation that their respective biases emerge dominant. Check out the paper and let me know if you agree. Would love to chat about this further.

      As for this article, I wanted to single out and shine light on the housing component because (1) it is the largest component of inflation and (2) I believe the removal of home prices from the inflation calculation has caused serious home affordability problems in the US (by mismatching inflation-linked wages and home prices).

  5. Atul Tiwary says:

    Great perspective. I live in the San Francisco Bay Area where Home prices have doubled since the lows. So I’m very sensitive to the change in the CPI measurements particularly the one that removed home prices from its calculations. If the monthly mortgage payment made by a home owner is considered equivalent to the monthly rent then wouldn’t the act of increasing interest rates increase inflation by increasing the monthly payments required to be made by new home owners and those with variable rate mortgages?

    1. Brodie Gay says:

      Hey Atul, you raise a very interesting question. If the FED raises rates and mortgage rates increase, the homeowner should demand more rent to maintain profitability of their homes. This is true in the long run, but history has shown another possibility. What if rates rise too quickly and rents are locked in (or there isn’t enough wage income in the area to support increased rents). In this scenario, the only way out is for homes to quickly decrease in value. This is exactly what happened in the 2008 crisis. Interest rates jumped and government fiscal spending decreased. The price level of homes became unsustainably high and many had to sell quickly.

      This is true for businesses as well. As the interest rate increases, businesses that may have been profitable at low borrowing rates may not be profitable in high interest rate environments. This is why the theory suggests that increasing the interest rate will drive down investments, wages and ultimately spending (inflation) in the short run.

  6. Ken Bernard says:

    That’s an interesting article. What data do you have to support the following:
    “Since rent growth has been much lower and less volatile than home price appreciation, the CPI currently understates this sensitivity.”

    1. Brodie Gay says:

      Hey Ken, thanks for the comment. The following link shows the National Home Price Index published by S&P/Case-Shiller and estimated rent of primary residence over time ( generated by FRED). Price returns have tended to be much more volatile than rents generated. Some of this disparity can be associated with lower overall resolution of estimating rents (rent data is harder to generate so variance in rents may be missed). However, we don’t believe this tells the whole story.

      Campbell and Shiller published an important paper studying the properties of price-to-dividend ratios in equity markets ( . They were investigating whether the source of variance in price-to-dividend ratios was due to (1) variance in the expected dividends or (2) variance in the discount rate used to turn those dividends into a present value (or price). Their conclusion was that dividends (and their growth estimates) contribute much less noise than changes in the discount rate.

      Why is this relevant? We can model home prices as the present value of discounted rents. Rents have historically been very stable over time (and grow at a very predictable rate). However, home discount rates (mortgage rates can be used as a rough proxy here) are much more likely to bounce around unexpectedly. The literature and the net present value model suggest that shocks to these discount rates amplify the variance of home prices in excess of the (relatively small) variance in projected future rent.

      To conclude, our claim is that by including rents and not home prices, the CPI misses a large source of variance and increases in the real liabilities of Americans (since a large percentage of Americans are homeowners). By biasing the CPI downwards, Americans whose incomes depend on CPI to properly track their future costs will be forced to cut back on consumption. This violates the intent of CPI.

  7. Cheech says:

    “Because changes to the measurement methodology of inflation in 1983 have led to the persistent understating of real rising price levels for the median household, thereby clouding the Fed’s policy decisions.”

    I’m unclear how a methodology change in characterizing inflation starting 35 years ago underestimates inflation from year-to-year starting 10 years ago. Is the inflationary effects of doubling M2 reflected in non-housing CPI components being washed out by significant decreases in rental costs?

    “Since rent growth has been much lower”–

  8. Thoughtful Investor says:

    This article skims the surface of a complex issue:
    1. The time frames of the various graphs are all different. For example, how has home ownership gone before and after 1983 not 2008.
    2. If the CPI methodology has changed for the “worse”, how has CPI compared to other inflation measures such as PPI or GDP deflator? I don’t recall a smoking gun showing dramatic differences over the long term.
    3. Household income is a bit of a problem because households have been shrinking over the longer term.

Leave a Reply

Your email address will not be published. Required fields are marked *

By continuing to use the site, you agree to the use of cookies. more information

The cookie settings on this website are set to "allow cookies" to give you the best browsing experience possible. If you continue to use this website without changing your cookie settings or you click "Accept" below then you are consenting to this.