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The Consumer Price Index (CPI), a critical economic indicator, ostensibly measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Yet, as comprehensive as it strives to be, the CPI omits a pivotal component of modern economic life: interest rates. As discussed on Derek Thompson’s podcast Plain English, this omission likely leads to a misrepresentation of the true cost pressures faced by consumers and could misguide policymakers navigating the tempestuous seas of economic policy. Derek is 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

The CPI is more than just a list of numbers—it’s a mirror reflecting the economic experiences of average Americans, from Anchorage to Miami. Developed during World War I, the CPI was initially a tool to adjust wartime wages. Today, it influences decisions from the Federal Reserve’s interest rate adjustments to Social Security’s cost-of-living increases. The index tracks expenditures in categories such as housing, which accounts for about 42% of the CPI basket, food (about 14%), and transportation (around 16%), among others. These percentages, based on the Bureau of Labor Statistics’ 2021 data, underline the weights assigned to various expenses in average consumer budgets.

Interest rates were removed from the U.S. Consumer Price Index (CPI) in 1983 as part of a shift towards a more focused measurement approach. This change was driven by several key reasons:

• Focus on Consumer Prices: The revision aimed to concentrate the CPI strictly on the prices consumers pay for goods and services, excluding factors like interest rates, which were considered financial transactions rather than direct consumer purchases.
• Adoption of Cost of Living Framework: The change supported a move towards a Cost of Living Index, which aims to measure the cost required to maintain a constant standard of living, rather than capturing investment-related expenses (a lot of homes are purchased as investments or at least partially as an investment). As Judd Cramer mentions in the Plain English podcast

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.

• Clarification of Price Movements: By excluding interest rates, the CPI sought to provide a clearer picture of pure price movements in the consumer goods and services market, avoiding the skew that financial market fluctuations can cause.

This modification in the CPI’s structure was intended to enhance its accuracy as an indicator of everyday consumer expenses, though it also initiated ongoing discussions about the breadth and applicability of the CPI as a measure of economic health. Instead of the direct interest rate costs the CPI includes Owner’s Equivalent Rent (OER), which estimates what homeowners would pay in rent for a comparable residence.

Sweden and Iceland include mortgage interest rates in their consumer price indices. In contrast, Canada, the UK, and Australia exclude these rates but incorporate other direct homeownership costs such as property taxes and maintenance expenses in their CPI calculations.

To understand the integral role of interest rates in the economy, one must first grasp what they are: essentially, the cost of borrowing money. They are pivotal levers in monetary policy, wielded by central banks to control economic growth. For instance, lower interest rates reduce the cost of borrowing, encouraging businesses to invest and consumers to spend, thereby stimulating economic activity. Conversely, higher rates can help cool an overheating economy.

For those of you in finance, this next paragraph is glaringly obvious, but it’s important to note the interplay between interest rates and the economy as a dance that’s as old as any modern financial system. For example, during the early 1980s, the U.S. faced soaring inflation, peaking at 14.8% in March 1980. In response, the Federal Reserve, under Chairman Paul Volcker, raised the federal funds rate to a historic high of 20% in June 1981. This drastic measure led to a recession but was successful in getting inflation under control, showcasing the profound impact interest rates have on the economy.

Today, the manipulation of interest rates continues to be a primary tool for managing economic stability. Lowering the Federal Funds Rate to near zero during the 2008 financial crisis and again in March 2020 during the onset of the COVID-19 pandemic are cases in point. These decisions aimed to mitigate economic downturns by making money cheaper to borrow, hoping to spur spending and investment.

Interest rates also directly impact consumer behavior. Consider the housing market, a sector that is acutely sensitive to changes in interest rates. When rates drop, mortgages become cheaper, leading to an uptick in home buying. This was evident in the post-2008 recovery period and during the pandemic when low rates led to a booming housing market despite broader economic uncertainty.

Given this backdrop, the absence of interest rate considerations in the CPI seems a significant oversight. Their inclusion could provide a more nuanced view of the economic landscape faced by consumers and offer policymakers a clearer picture when crafting fiscal and monetary policies. As we delve deeper into the implications of their inclusion, it becomes apparent that the current CPI, while useful, might be providing a slightly out-of-focus economic picture.

the case for including interest rates in the CPI

• Direct Impact on Consumer Behavior Interest rates directly influence consumer decisions on large purchases that require financing, such as homes and automobiles. For instance, a drop in mortgage rates typically leads to an increase in home buying, as lower interest costs make purchasing more affordable. Similarly, car sales often rise when auto loan rates fall. This direct linkage between interest rates and consumer spending behaviors suggests their inclusion in the CPI would provide a more accurate reflection of economic conditions as they affect consumer choices.
• Influence on Major Economic Sectors Interest rates have a profound impact on the housing market and the broader business investment landscape. For example, changes in interest rates can dramatically alter the construction sector’s dynamics, affecting everything from residential building rates to real estate prices. Additionally, interest rates affect corporate investment decisions, influencing how companies allocate resources to expansion projects or equipment purchases. Including interest rates in the CPI would offer a more holistic view of how monetary policy and economic conditions influence these vital sectors.
• Enhancing Policy Responsiveness Incorporating interest rates into the CPI could lead to more responsive and effective monetary policy. By providing a clearer picture of the economy’s reaction to changes in interest rates, policymakers can better gauge the impact of their decisions on inflation and consumer spending. This could lead to more timely adjustments in monetary policy, potentially stabilizing economic cycles and reducing the severity of recessions and booms.

counterarguments

• Volatility of Interest Rates One counterargument against including interest rates in the CPI is their volatility. Interest rates can fluctuate significantly over short periods, potentially introducing more noise into CPI measurements. However, this concern can be mitigated by using averages or smoothing techniques over longer periods to capture underlying trends without the short-term fluctuations.
• Complexity in Measurement and Interpretation Another challenge is the added complexity in measuring and interpreting the CPI. Interest rates differ by loan type, risk level, and duration, complicating their integration into a single index. Nevertheless, methodologies can be developed to incorporate weighted averages of key interest rate indicators, such as mortgage rates and consumer lending rates, to reflect their overall economic impact effectively.
• International Approaches Looking at how other countries handle similar indices could provide valuable insights. Some nations include homeowner costs related to mortgage interest payments in their consumer price measurements, which could serve as a model for integrating certain types of interest rates into the CPI.

consequences of a change

The inclusion of interest rates in the CPI would likely lead to more informed monetary policy decisions. With a more accurate measure of inflation that accounts for the cost of borrowing, the Federal Reserve could better manage interest rate adjustments to achieve its dual mandate of controlling inflation and maximizing employment.

For consumers, a CPI that includes interest rates could mean more predictable pricing and borrowing costs, as adjustments in monetary policy would be more closely aligned with real-world economic conditions. Businesses would benefit from clearer signals about consumer purchasing power and economic trends, aiding in planning and investment decisions.

Over the long term, the proposed changes could contribute to greater economic stability. By aligning the CPI more closely with economic realities, there would likely be fewer surprises in monetary policy adjustments, leading to smoother economic cycles and potentially faster growth.

Implementing this change would require significant research and testing. Pilot programs could be initiated to explore the feasibility of various methodologies for including interest rates. Additionally, engaging with economic researchers, policymakers, and the public to gather feedback and build consensus is crucial.

Incorporating interest rates into the Consumer Price Index (CPI) is more than a technical adjustment; it’s a critical update to better reflect the economic pressures facing consumers and businesses today. As our financial landscape grows in complexity, our economic indicators must evolve to offer a more accurate view of inflation and overall economic health.

The inclusion of interest rates in the CPI promises a richer, more nuanced tool for policymakers, enhancing their ability to make informed decisions that impact economic stability and growth. Achieving this will require collaborative efforts among economists, statisticians, policymakers, and the public, but the potential benefits—more precise economic measurements and effective policy responses—are substantial.

While refining the CPI will be challenging, the pursuit of a more comprehensive economic understanding is essential. This evolution of the CPI will not only improve our current models but also equip us to navigate future economic challenges more effectively.