A Better Way to Measure Inflation

Matthew C. Klein writes for Bloomberg View about the economy and financial markets. He previously wrote for the Economist magazine and its economics blog, Free Exchange.
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At what was almost certainly his final appearance before Congress as the chairman of the Federal Reserve, Ben Bernanke was asked whether government statisticians are undercounting the "real" rate of inflation. He responded by discussing the difficulties in measuring the cost of living and suggested that the widely-followed Consumer Price Index probably overstates inflation rather than understates it.

Bernanke is probably right -- if we're only talking about the rate of price increases of things we buy in stores, like food and soap, or services, like haircuts and dry cleaning. The problem is that most people also have to spend money on assets that they hope will provide for them when they retire. A comprehensive measure of the cost of living ought to account for this. None currently does.

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.

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.

We don't currently have very good ways of measuring the size of these effects. That doesn't mean economists should pretend they don't exist when talking about the cost of living.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.