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Inflation in America may be even worse than thought

Changes to the construction of the consumer-price index have distorted comparisons

America’s federal reserve, which is set to meet on June 14th and 15th, has a difficult task ahead of it. Consumer prices in May were 8.6% higher than a year earlier—the greatest increase since 1981. Petrol prices, in nominal terms, are at a record high. And geopolitical tensions are weighing on economic growth. One source of comfort is that May’s official reading pales in comparison with the Great Inflation that American consumers endured during the 1970s and early 1980s. But new research suggests that comparing past and current levels of inflation in America may be misleading.

Such comparisons are fraught because of methodological changes made to the consumer-price index (CPI) in the 1980s. For decades the housing portion of the CPI was estimated based on the costs incurred by homeowners, including house prices, mortgage rates, property taxes and maintenance costs. But government statisticians eventually realised that this approach overstated the true cost of housing. It produced a volatile measure of housing inflation that fluctuated with interest rates (increasing sharply during tightening cycles and falling in easing ones). In 1983 the Bureau of Labour Statistics (BLS) switched to a new method for calculating the CPI that relied on estimates of what homeowners would earn if they rented out their homes, a measure known as owners’ equivalent rent.

To understand how this change may have distorted historical inflation, the paper’s authors, Marijn Bolhuis, Judd Cramer, and Larry Summers, a former treasury secretary, reconstructed the CPI for the period between 1946 and 1983 using the BLS’s current method for estimating housing costs. They found that the double-digit inflation of the 1970s was in fact lower and less volatile ​​than the official data would suggest: the 14.8% peak rate recorded in March 1980 would have instead come in at 11.4%. The peak core inflation rate of 13.6% in June that year would have been 9.1%.

Current inflation levels are thus closer to historical peaks than the official data would suggest. What lessons can be drawn from this? Some analysts think that the Federal Reserve will be able to achieve a “soft landing”—where tightening monetary policy brings down inflation without harming growth—something it has pulled off only three times since 1945. But Mr Summers and his co-authors reckon that the Fed’s current tightening cycle will be much more painful. Paul Volcker, who presided over the Fed during the Great Inflation, tamed the beast only by pushing the economy into a deep recession. The historical statistics may be providing false comfort by suggesting that the Fed was then fighting a much worse inflation problem than today’s. The authors warn that hitting the 2% inflation target will require nearly the same amount of disinflation as achieved under Volcker. 

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