Power & Market

The Fed’s New Inflation Measure Moves Beyond Consumer Prices

The Fed’s New Inflation Measure Moves Beyond Consumer Prices

If you’ve been shopping for real estate or stocks lately, you might be wondering how the Fed gets away with all that talk about how inflation is “low,” “muted,” or “below expectations.”


The reason for this is the Fed largely bases policy on consumer prices, rather than on a broader measure that might include a variety of assets. The Fed often even excludes food and energy from its inflation measure.

Needless to say, this leaves much to be desired from any true measure of inflation. As Brendan Brown has explored multiple times here at mises.org, asset prices are a key indicator of where we are in the business cycle, and are essential in evaluating the real effects of monetary policy.

Recognizing that consumer prices are doing a bad job at giving us a true picture of the economy, the New York Fed in September released a new measure of inflation called the Underlying Inflation Gauge (UIG) which takes into a account a broader range of products, services, and assets.

Not shockingly, the UIG shows a higher rate of inflation than the CPI, and also shows a different trend. the UIG has been increasing in recent years while consumer price trends have been falling.

In October, the CPI measure was 2.0, while the UIG measure was 2.9. Moreover, the UIG measure is at the highest level recorded since September 2006, near the height of the last housing bubble.

The implications for monetary policy can also be seen in the graph. While consumer price growth (according to the CPI) was plummeting in 2014 and 2015 — bottoming out at -0.2 percent in April 2015 — the UIG measure was holding much more steady. It hasn’t fallen below one percent since the last recession.

Last week at Bloomberg, Joseph G. Carson delved into what we can learn about monetary policy using the new measure: 

Some may argue that the recent explosion in asset values could be tied to the new technological advances and gadgets. While these new innovations have clearly added value to the economy and created enormous wealth in the process, they cannot fully explain the broad surge in all types of real and financial asset values.

In a fundamental sense, asset values are highly contingent on the current level of and future expectations for inflation and interest rates. To be sure, a persistently low inflation rate suggests little downside risk to the economy, creating a vision of endless and uninterrupted economic growth, boosting investor confidence and risk taking. 

Monetary policy has played a key role in asset price cycles. Not only has the Federal Reserve used its balance sheet to buy trillions of dollars of financial assets, boosting the values of all type of assets and anchoring long-term rates in the process, it also directly linked its official rate decisions to a specific rate of consumer inflation. The transparency of its future policy path has created the impression of an accommodative monetary policy, encouraging more risk-taking in asset markets...

The UIG carries three important messages to policy makers: the obsessive fears of economy-wide inflation being too low is misguided; monetary stimulus in recent years was not needed; and, the path to normalizing official rates is too slow and the intended level is too low.

Harvard University professor Martin Feldstein stated in a recent Wall Street Journal commentary that “The combination of overpriced real estate and equities has left financial sector fragile and has put the entire economy at risk.” If policy makers do not heed his advice odds of another boom and bust asset cycle will be high -- and this time they will not have the defense mechanisms they had after the equity and housing bubbles burst. 

Here at mises.org, of course, we’ve explored the problem with the “two-percent” standard for inflation, while noting the problem with ignoring asset prices. 

I do not share the Fed’s hope that we can tinker our way to an especially good measure of price inflation via the usual empirical measurement tools. But some measures are indeed better than others, and it is good to see that even the Fed is admitting that the long habit of picking and choosing a quite limited number of consumer prices has been especially bad in analyzing where we are in the boom-bust cycle. 

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