Interest Is a Cost and Contributes to Inflation and Inflation Expectations

I have been making this point for some time and it is nice to see some research support for the view that interest rates, which reflect the cost of money, should be viewed as a core part of inflation and influence consumers views of inflation.  A new paper at the National Bureau of Economic Research supports that perspective.  The authors wondered why consumers often recently have expressed poor consumer sentiment while the economy appears strong and inflation is falling, according to official measures.  They found a strong correlation between interest rates and consumer debt levels and consumer sentiment.  The same phenomenon exists in other countries as well.

It has never been clear to me why the cost of money isn’t included in price inflation indices and these researchers construct one that does it include.  I suppose the theory is that those interest costs are embedded in the price of goods and services, but that appears not to be the best way to measure their impact on consumers.  The interest costs on a typical 30 year mortgage are up threefold in the last few years and car loan rates up by 80%.  These are real pocketbook issues for consumers.   Before 1983 CPI measures did take interest rates into account but economists were persuaded to drop them and in regard to housing for example, use alternative approaches that ignore something that is very front and center to consumers.  Housing is 30% of average household expenses, a car is over 10% and credit cards are used for the bulk of consumer spending.

Yesterday I posted in part on the rise in rates, credit card debt and delinquencies.  For many people, credit cards are a vital tool for managing monthly spending and they are certainly aware of increases in their cost.  This is reflected in surveys that show consumer concern about the cost of money is at a record high.  Using an alternative approach to consumer prices shows that, while much of the time it tracked CPI, in the last couple of years, when official inflation reached as high as 9%, the alternative method including interest costs increased to as much as 19%.  And that explains why consumers don’t buy the argument that inflation is a lot better and the average person feels as stretched financially as they ever have. (NBER Paper)