Let's Not Invent New Ways to Measure Higher Inflation

Matthew Klein of Bloomberg View has just posted an interesting article called "A Better Way to Measure Inflation." He writes:

Sooner or later, most people end up retiring. You may not be working, but you still need money to eat and live. In the U.S., retirees get some income from Social Security, while Medicare covers their healthcare expenses. These programs by themselves aren't enough for most people, which is why it's a good idea to take some of the money you earn during your working life and use it to buy assets that can be consumed later. 

The amount of money you need to spend on assets to guarantee a given standard of living in retirement is determined by your assets' average yield. The higher the yield on your assets, the less money you need to spend today to get an equivalent amount of money in retirement. Falling yields therefore mean you need to spend more money today to guarantee the same amount of money in the future. In other words, the price of retirement, which is a price almost everyone is exposed to, goes up when yields go down.

The Consumer Price Index calculates inflation as the percent change in the price of a "market basket" of goods and services. Klein implies that the Consumer Price Index understates inflation because retirement is left out of the market basket.

"Consumption smoothing" is the usual name for the fact that people want to spread their consumption across their lifetime more smoothly than their income. For example, when people retire and have little or no income, they still want to consume around the same amount as they did before, as Klein describes. So over the lifecycle, a typical person will try to borrow (reduce their net assets) when their income is low and save (increase their net assets) when their income is high. Interest rates, and correspondingly, yields, figure prominently in the analysis of lifetime consumption.

I am a teaching assistant for undergraduate macroeconomics this summer, and we have been teaching the students a variety of different ways to think about interest rates. One way we explain is that interest rates are like a "price" in the market for loanable funds. They are familiar with supply and demand curves from their prerequisite course, so we show them a graph like this:

Klein, I think, is implying that Fed policy has shifted the supply curve to the right, lowering the real interest rate, making the price of loanable funds lower and in turn making the cost of saving for retirement higher. He pays attention to the second part (the higher price of saving), but not the first part (the lower cost of borrowing.) He says that:

People who already own a lot of assets tend to see things differently. For them, falling yields are great because it means that the value of their savings is rising relative to their other expenses. By contrast, workers struggling to save for retirement have to cut back on current purchases of goods and services in order to cover the added cost of their future liabilities. Rising yields have the opposite effect: it makes the asset-rich feel poorer and makes the asset-poor freer to spend more today.

Monetary policy does have different effects on different people, for a variety of reasons, but not really in the way Klein describes. He is considering only people who are currently increasing their net assets. In terms of lifetime consumption models, these are people who are in a part of their lifecycle when their current income is higher than their expected average future income. (These people have earnings above the red line in the figure below.) What he calls the "asset-rich" and the "asset-poor" do not together make up the entire population-- and a lot of "struggling workers" would not accurately fit into his characterization of the "asset-poor."

Especially when unemployment and underemployment are high, a lot of people's current income is lower than their expected average future income. (Somewhere around the blue star in the figure below.) These people are quite rational to want to spend more than their current income. Rising yields would certainly not make them "freer to spend more today." Klein's "asset-poor" leaves out the people with falling (and in many cases also negative) net assets.  In short, Klein argues that our measured inflation leaves out the price of consumption smoothing, but he only considers the saving part of consumption smoothing, and not the borrowing part.

Image Source: Kotlikoff and Burns (not including blue star)

I hope the Fed does not start finding inflation where it doesn't exist as an excuse to raise rates.