How lags in statistics skew the inflation picture
If you’re a normal human trying to read recent economic news, especially about inflation, you might be feeling confused right now. You may have seen reports that consumer prices are up 3.1% over the past year, which sounds bad; “core” inflation, which excludes volatile food and energy prices, was 4%, which sounds worse.
Yet many commentators are saying that the Federal Reserve’s fight against inflation is more or less done, and financial markets expect the Fed to reverse course soon, cutting interest rates instead of increasing them. How can this make sense?
In a technical sense, it’s all about the lags. In a deeper sense, there are a range of inflation measures, and which one you should choose depends on what question you’re trying to answer.
Cooler than it appears
Here are two measures of inflation in recent years: the oneyear change in the core consumer price index and the sixmonth change in the core personal consumption expenditure deflator — a measure that’s conceptually similar but different in detail — expressed at an annual rate. The latter measure was only 2.5% for the six months ending in October, and most analysts expect that when the November number comes in Friday, it will be close to 2%, the Fed’s target.
These measures look different. Part of why is that if inflation is falling rapidly, which seems to be the case, looking at the change in prices over a whole year literally puts you behind the curve; a lot of what you’re capturing is stuff that happened a while ago, rather than what is happening now.
In that case, however, why not look at month-to-month changes? Noise: There’s too much randomness in monthly data to make it a reliable indicator. Taking a six-month average is a compromise that cancels out a lot of the noise but gets you reasonably close to current events.
But that’s not the whole story. These are two measures of consumer prices. And right now, the deflator — which the Fed normally prefers, in any case — is a much better indicator than the consumer price index of how the fight against inflation is going. Why? Again, the answer is lags, specifically involving housing.
Choosing the right ruler
The cost of housing makes up around one-third of the consumer price index and about 40% of core CPI. The Bureau of Labor Statistics measures housing costs using rents — the rents people actually pay if they are, in fact, renters, and an estimate of the rents they would be paying if they own their houses. Normally, this procedure raises few problems.
But most renters are on leases, so the average rent people are currently paying lags behind market rents — what people pay for newly rented dwellings. But there was a huge surge in market rents in 2021-22, probably reflecting the rise in remote work: People working from home wanted more home to work from. This surge has now subsided, but it’s still filtering into the standard rent numbers.
The difference between growth in “new tenant rental rates” and official rents tells us that a lot of measured consumer price inflation reflects stuff that happened many months ago, not what’s happening now. And for technical reasons, the deflator puts a lower weight on housing, so it’s less affected by this lag.
Which of these measures is right? As I said, it depends on what question you’re trying to answer. The Fed is trying to decide whether it should raise or lower interest rates, so it’s looking for indicators of whether the economy is currently running too hot, too cold or just right. For that purpose, something like the six-month change in the deflator is better than the annual change in the consumer price index, which is strongly affected by factors that are now in the rearview mirror.
And this measure suggests that the economy is no longer running hot and may be getting colder. So it’s time to think about rate cuts.
Reason for optimism
The overall picture is actually pretty good. Inflation does seem to be coming under control without the high unemployment many economists thought would be necessary. Workers seem to have come through a turbulent period of the pandemic and inflation with higher purchasing power than they had before.
There is also a broader lesson. People often want to judge the economy by a single statistic, like the annual inflation rate. But numbers don’t speak for themselves. They can be used to help tell a story; they aren’t the story on their own.