What Many Economists (and I) Got Wrong About This Economy

One of my New Year’s resolutions for 2024 was to do more episodes with people who think I’m wrong about something. For example, I’ve done several episodes about how the U.S. economy is doing much better than most Americans think. Today’s guest says my analysis (and that of many economists and economic commentators) is missing something big. Official inflation measures do a poor job of capturing the effect of higher interest rates. When a home goes from $200K to $220K, that’s a 10 percent increase in the value of the home. But, with higher rates, the monthly cost of living in that house with a mortgage might go up 300 percent. The same is true for financing a new car with higher interest rates. Or paying credit card debt. Judd Cramer, an economist who teaches at Harvard University, is the coauthor of a new paper on how our inflation data doesn’t properly account for skyrocketing interest rates—and why the so-called “vibecession” isn’t as much of a mystery as we think.

If you have questions, observations, or ideas for future episodes, email us at [email protected].

In the following excerpt, Derek and Judd Cramer explore why a change to how inflation is measured has led to a discrepancy between how economists and consumers feel the economy is performing.

Derek Thompson: So, as I recounted in the open, listeners know all too well that I am fascinated by the question of how to reconcile all of these expert economists saying the economy is booming and all of these Americans saying, “No, it actually kind of stinks.”

Now, your paper is fascinating because you are a bunch of economists, but rather than side with the economists, you are siding with the people. You are essentially saying economists have looked at this picture all wrong, and they’ve been led astray by their tools that they use to analyze the economy. So let’s start with these tools. A lot of economic commentators, like me, when we look at the economy, look at inflation, and look at unemployment, you put them together: It’s called the misery index. Maybe give us a little bit of history. What’s the misery index? Where did it come from? And why might it be the wrong way to look at the economy today?

Judd Cramer: Yeah, so the misery index was invented by Arthur Okun in the 1970s, and it really encapsulated the stagflation that we were seeing in the 1970s during the Carter administration, when people were really feeling bad about the economy. And so what we did is we took inflation (how the prices of goods were changing) and unemployment, and we put those two things together. And as they were both rising for the first time together in our history, people were really unhappy about that. So we have used, since the 1970s, this misery index as our main indicator of: How do we think consumers will be feeling about the economy?

Thompson: And what’s wrong with it? Why can’t we just keep using it today in 2024?

Cramer: And one of the problems that we point out in this paper is actually the way that we measure inflation, so the CPI—the consumer price index that we look at every month—the way that we’re measuring that changed a lot in the 1980s and in the 1990s. So even though we have the same misery index that was invented by Arthur Okun, right now it’s capturing something completely different.

Thompson: All right, so let’s talk about what it’s capturing. The way we measure inflation changed in the early 1980s. Tell me exactly how, and I believe it relates specifically to housing in particular.

Cramer: Yeah, the biggest change was how we measure what we call “shelter inflation.” And this really matters today because shelter inflation is about 40 percent of the core of the consumer price index. So it’s something that Wall Street is looking very closely at every month. Before the change in 1983, what we used to measure is: If you want to buy a new house, how much is that going to cost you in terms of what housing prices are, what the mortgage rates are, what insurance costs are? And we would put all of those together into a homeownership variable before, in 1983.

There are a couple problems with that measurement. When somebody buys a house, they’re not only buying a house to live in it this year; they’re buying a house to live in it for the next five to 10 years. Also, when they’re buying a house, they’re perhaps buying it for investment reasons instead of just for consumption reasons. So because of that, based off of theoretical reasons, the Bureau of Labor Statistics actually has taken housing prices out of the consumer price index since 1983.

So now when we measure the costs of housing, we’re actually just looking at rent prices, and we are saying for homeowners: How much money would you have gotten if you were to have rented out your house for the year? And so that’s what we’re using as the measure of house prices. And it has a few distortionary effects on the measure of the CPI. Most importantly, for our discussion, is that it used to include mortgage costs, so interest rates used to really enter into the CPI, and now mortgage costs are completely absent. So now we see no responsiveness of the CPI to interest rates.

Thompson: I see. So in 1981, if interest rates spiked, and they did spike in 1981, it would show up in shelter inflation. But today, when interest rates spike and people who buy new homes and have to pay that higher 30-year mortgage rate are paying much higher rates than they would’ve if they had bought a home in 2019, that isn’t reflected in shelter inflation. Is that what you’re saying?

Cramer: Completely correct. Yes. Mortgage rates are not included at all. Neither are housing prices, which strikes people as a little confusing because they know that housing plays such a large part in their own finances.

Thompson: Before we talk about the thesis of your paper, and I’m sure a lot of people understand now the thesis of your paper is centered around interest rates, I want to give a good-faith analysis of why this change happened. I mean, economists who made this change couldn’t have been absolutely stupid. They might have only been slightly stupid. Clearly, they were looking at something real when they said, “We need to stop including interest rate payments in the cost of housing.” Why make this change?

Cramer: I think there are two reasons to highlight. And yes, I completely agree with you that people at the BLS do a great job, and they’re estimating what they’re tasked with estimating. Two reasons why we excluded mortgage costs from the index were, first, as interest rates were spiking under Paul Volcker and they were in the 20s, the number of people who were actually able to qualify for a mortgage and get a mortgage went down substantially. So if most people who were buying houses were not doing it with a mortgage, it didn’t make sense to keep track of mortgage costs as closely as we used to.

And secondly, in general, we are just worried when somebody is buying Bitcoin, for example, it’s an investment, or if they’re buying Goldman Sachs stock, it’s an investment. That’s not something that we include in the consumer price index because that’s something that you are buying because of its future benefits. And in the same way, when somebody’s buying a house and they’re getting a 30-year mortgage, it’s really hard to say of that 30-year mortgage on that house, you are going to consume this much shelter today and this much shelter tomorrow and this much 30 years in the future. And because the BLS doesn’t have a great way of ascertaining which share of consumption falls in which year, they’ve punted on the issue and just looked at rental rates to try to impute what your actual consumption of shelter is.

This excerpt was edited for clarity. Listen to the rest of the episode here and follow the Plain English feed on Spotify.

Host: Derek Thompson
Guest: Judd Cramer
Producer: Devon Baroldi

Subscribe: Spotify