Plain English with Derek Thompson - What Many Economists (and I) Got Wrong About This Economy

Episode Date: March 5, 2024

One of my New Year’s resolutions for 2024 was to do more episodes with people who think I'm wrong about something. For example, I've done several episodes about how the U.S. economy is doing much better than most Americans think. Today’s guest says my analysis (and that of many economists and economic commentators) is missing something big. Official inflation measures do a poor job of capturing the effect of higher interest rates. When a home goes from $200k to $220k, that’s a 10 percent increase in the value of the home. But, with higher rates, the monthly cost of living in that house with a mortgage might go up 300 percent. The same is true for financing a new car with higher interest rates. Or paying credit card debt. Judd Cramer, an economist who teaches at Harvard University, is the coauthor of a new paper on how our inflation data doesn't properly account for skyrocketing interest rates—and why the so-called "vibecession" isn’t as much of a mystery as we think. If you have questions, observations, or ideas for future episodes, email us at [e-mail].  Host: Derek Thompson Guest: Judd Cramer Producer: Devon Baroldi Learn more about your ad choices. Visit podcastchoices.com/adchoices

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Today's episode is about why I'm wrong. So a half step back, one of my new year's resolutions for 2024 was to do more episodes about why some position I've staked out or some argument that I've put forward with another guest might miss a bigger truth. I wanted to talk to people who think I got something wrong or left something incomplete. For today's inaugural, Why I'm Wrong episode, we're going to start with the economy. For the last few months, I have gone on and on and on and on about how the economy is better than most Americans think. If you've listened to me at all, you know the drill. Real inflation-adjusted wages are up. Productivity is rising. Income inequality is falling. Income is rising most for the poorest Americans. Inflation is falling. And if you're lucky enough to have some savings attached to the essential.

P500, your portfolio is up to. Now, all of these things are true, but I still might be wrong. A few episodes ago, I did a show with the economist, Aaron DuBé, where we talked about how real wages, inflation-adjusted wages, are rising most for the poor. And I heard some feedback from that show that I want to spend a bit of time recounting here before we get to the meat of this episode. First, some people said, you didn't talk enough about the fact that low-income people face the highest inflation.

Inflation is an average figure. It captures the average cost of a basket of goods, but the average basket of goods for someone at the 90th percentile is very different than for someone at the 10th percentile. There is no actual average American. It's usually the case that lower-income people are dealing, therefore, with higher rates of inflation, right? So right now they might be seeing the highest wage increases,

but they're also being walloped with the highest price. increases. That's number one. Second, people said, you didn't talk about transfers, money that people get from the government. So if you look at a time series of poverty data, the poverty rate set historic lows in 2020 and 2021, when the U.S. went to historic length to send checks to people. For a while, we even sent families an expanded child tax credit. But then the check stopped, and poverty increased in 2022 and 2023. The excellent economic analyst Joey Politano made this point very well in his newsletter A Persitas.

He said the expiration of the expanded child tax credit in 2022 cost the median household about 3% of their nominal income. That's not nothing. So putting it together, yes, poor Americans are seeing faster wage growth, but they're also seeing faster price growth, and their checking accounts have taken a hit as government welfare has pulled back during the Biden administration.

Now, why I'm wrong, reason number three. Today's guest says my analysis and the analysis of many economists and economic commentators is missing something big. Official inflation measures, the ones that I rely on to understand the world, do a poor job of capturing the effect

of higher interest rates. So when a home goes from being worth $200,000 to $220,000, that $20,000 increase divided by $200 means you have a 10% increase in the value of the home, roughly 10% inflation. But if mortgage rates go from 3% to 7% and you're getting a mortgage to buy this home, well, the monthly cost of living in that house and paying those higher interest rates, it might not go up 10%, it might triple, going up 200%. The same would be true for financing a new car with higher interest rates, or paying credit card debt with higher interest rates.

Higher interest rates don't just punish consumers who take on debt. They haunt consumers who even think about debt. And when economists capture the pain factor and the fear factor of high interest rates that aren't being captured by typical inflation data, they say, you know, actually the so-called mystery about why Americans are sour on the economy, it's not nearly so mysterious. Today's guest making this argument is Judd Kramer, an economist who teaches at Harvard University. He's the co-author of a new paper on how our inflation data does not properly account for higher interest rates. We talk about why economists might be looking at a distorted view of the economy,

why the classic misery index of the 1970s utterly fails to account for today's economic misery, and why I might be, in a word, wrong. I'm Derek Thompson. This is plain English. Judd Kramer, welcome to the show. Thanks for having me. So as I recounted in the open, listeners know all too well

that I am 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. Now, your paper is fascinating because you are a bunch of economists

But rather than side with the economists, you're siding with the people. You're essentially saying economists have looked at this picture all wrong, and they've been led astray by their tools that they use to analyze the economy. So let's start with these tools. A lot of economic commentators like me, when we look at the economy, look at inflation and we call unemployment, you put them together. It's called the Misery Index. Maybe give us a little bit of history.

what's the misery index, where did it come from, and why might it be the wrong way to look at the economy today? Yeah, so the misery index was invented by Arthur Oaken in the 1970s, and it really encapsulated the sort of stagflation that we were seeing in the 1970s during the Carter administration when people were really feeling bad about the economy. And so what we did is we took inflation, how the price of goods were changing, and unemployment, and we put those two things together, and as they were both rising for the first time together in our history, people were really unhappy about that. So we have used since the 1970s this misery index as our main indicator of how do we think consumers will be feeling about the economy.

And what's wrong with it? Why can't we just keep using it today in 2024? And one of the problems that we point out in this paper is actually the way that we measure inflation, so the CPI, the consumer price index that we look at every month, actually the way that we're measuring that changed a lot in the 1980s and in the 1990s. So even though we have the same misery index that was invented by Arthur Okun, right now it's capturing something completely different. All right. So let's talk about what it's capturing. The way we measure inflation changed in the early 1980s. Tell me exactly how, and I believe it relates specifically to housing in particular. Yeah, so the biggest change was how we measure what we call shelter inflation. And this really matters

today because shelter inflation is about 40% of the core of the consumer price index. So it's something that Wall Street is looking very closely at every month. Before the change in 1983, what we used to measure is if you want to buy a new house, how much is that going to cost you in terms of what housing prices are, what the mortgage rates are, what insurance costs are, and we would put all of those together into a home ownership variable before in 1983. So there are a couple problems with that measurement. When somebody buys a house, they're not only buying a house to live in it this year. They're buying a house to live in it for the next five to 10 years. Also, when they're buying a house, they're perhaps buying it for investment reasons instead of just for consumption reasons.

So because of that, based off of theoretical reasons, the Bureau of Labor Statistics, actually has taken housing prices out of the consumer price index since 1983. So now when we measure the costs of housing, we're actually just looking at rent prices. And we are saying for homeowners, how much money would you have gotten if you were to have rented out your house for the year? And so that's what we're using as the measure of house prices. And it has a few distortionary effects on the measure of the CPI. Most importantly for our discussion is that it used to include mortgage costs. So interest rates used to really enter into the CPI, and now mortgage costs are completely absent. So now we see no responsiveness of the CPI to interest rates. I see. So in 1981,

if interest rates spiked, and they did spike in 1991, it would show up in shelter inflation. But Today, when interest rates spike and people who buy new homes and have to pay that higher 30-year mortgage rate are paying much higher rates than they would have if they had bought a home in 2019, that isn't reflected in shelter inflation. Is that what you're saying? Completely correct, yes. Mortgage rates are not included at all. Neither are housing prices, which sort of strikes people as a little confusing because they know that housing plays such a large part in their own finances. Before we talk about the thesis of your paper, and I'm sure a lot of people understand now, thesis of your paper is centered around interest rates. I want to give a good faith analysis of why this

change happened. I mean, economists who made this change couldn't have been absolutely stupid. They might have only been slightly stupid. Clearly, they were looking at something real when they said, we need to stop including interest rate payments in the cost of housing. Why make this change? So I think there are two reasons to highlight. And yes, I completely agree with you that people at the BLS do a great job and they're estimating what they're tasked with estimating. Two reasons why we excluded mortgage costs from the index were first, 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. So if most people who were buying houses were not

doing it with a mortgage, it didn't make sense to keep track of mortgage costs as closely as we used to. And secondly, in general, we are just worried when somebody is buying Bitcoin, for example, it's an investment, or if they're buying Goldman Sach stock, it's an investment. That's not something that we include in the Consumer Price Index, because that's something that you are buying because of its future benefits. And in the same way, when somebody's buying a house and they're getting a 30-year mortgage, it's really hard to say, of that 30-year mortgage on that house, you are going to consume this much shelter today and this much shelter tomorrow and this much 30 years in the future. And because the BLS doesn't have a great way of ascertaining which share

of consumption falls in which year, they've sort of punted on the issue and just look at rental rates to try to impute what your actual consumption of shelter is. Our inflation measure used to be really interest rate sensitive. And today, our inflation measures are interest rate insensitive, which means that if interest rates rise, that's not necessarily captured in CPI, in the inflation measures that we look at to use, figure out, how is this economy doing? Let's go straight to the thesis of your paper. Your paper is called, the cost of money is a part of the cost of living. What's the point? Yeah, the point, exactly, as you said, we used to include interest rates in the consumer price index, what we think of as the cost of living, and now they

aren't there. So as Americans have seen interest rates on their credit cards or on their car loans or on their mortgage rates shoot up in the post-pandemic period, that hasn't been reflected in the CPI. The thesis is if you ask a person on the street, is the interest rate part of your cost of living? They will say yes. They will say, I have to pay my credit card at the end of each month. And the interest rates on credit cards has gone from 17.5% to 22%. That's an increase that I have to bear. And the economists at the BLS and economists more generally, we say, well, the cost of living is what shows up in the consumer price index. And interest rates don't show up in the consumer price index. So actually, you person on the street are a little bit mistaken because the interest rates are not part of the cost of living.

And so what we do is we say maybe economists have fallen a little too in love with the current way we're measuring the consumer price index. And if we sort of think historically or more holistically about what the cost of living is for some of these other people in the economy, we would be a lot more sensitive to thinking about interest rate costs. And then what we show in the paper is if we include interest rate costs into the consumer price index, similarly to how it was done in the 1970s, then it turns out that the economy is not as great as everybody has been saying. And consumers' gloomy moods are a little bit more explainable. given that they've had to be dealing with these higher interest rate costs over the last few years. Reading from the paper right now, the interest rate on a new 30-year mortgage for the average house has increased more than threefold since 2021. The interest payment on a new car loan has increased more than 80%. So if you're an American who, and this is a relatively typical situation, you have credit card debt, maybe you want to lease a new car, maybe you want to get financing for a new car, maybe you're interested in buying a new house. Well, suddenly, you are playing around in

interest rate environments that require you to pay so much more than you had to three or four years ago. I mean, I don't know about you. I feel this among my own friends. My friends who, for example, are looking to, you know, looking at a new car or looking to buy a new house, they're looking back at what interest rates were five years ago, and they're thinking, Jesus Christ, I can't believe I have to pay this as an average monthly payment back to my bank. I mean, have you felt this as well among your cohort, this sort of this sticker shock at the interest rate environment? Yeah, sticker shock for sure. I am in the same group where I'm looking to buy a home. I'm currently renting a home in the Boston area these days. And the idea is that my friends who sort of timed

the market correctly and bought in 2020 or 2021 could be in a home, similar home to one that I might possibly end up in. But my monthly payments would be 70% higher than theirs is just absurd. something that is really striking and that I'm very much aware of. And we sort of saw as interest rates rose, the number of homes sold in the U.S. fell from $6 million to under $4 million. So people are definitely seeing the sticker shock, but also the number of transactions are going down substantially. But if we just look at the CPI, similarly to what you were saying, even though the costs

of financing a house or financing a car have gone way up, when we look at what's happened to shelter inflation, the U.S. it's only gone up, you know, at most 7%, 8% per year. The price of new cars have sort of, we've, the price of new cars in the CPI has shown them going down. But if we include these financing costs, both of those prices have gone up substantially. And now let's connect this story to the original topic that I talked about, which is the gap between what's sometimes called the hard data that economists look at and the consumer sentiment,

the way that Americans feel about the economy, when you and your co-authors factored in this new inflation measure, how much of the gap between hard and soft data did this new measure explain? So we were able to explain about 70% of the gap. So not all of it. There still seems to be a little bit of excess gloominess or bad vibes, depending on how you want to describe it, given what the hard data are.

But it's nowhere near as large as what you have. have gotten just having looked at unemployment and inflation. Got it. So the sort of the vibe session that people talk about that Kyle Skanlin, a friend of this pod cited in your paper that she talks about 70% of that vibe session is accounted for when you guys looked at this new measure of inflation that paid much more attention to the interest rates that Americans are actually paying on cars, houses, and credit cards. Let me tell you, this is, you know, I'm structuring this episode as a why I'm wrong

episode, and I want to be clear that I think I have been wrong, potentially, to not emphasize the cost of money as you did in this paper. But it's not as if I'd never talk about interest rates. Some people think I'd talk about them too much. We've done episodes on what a miserable housing market this is. I've mentioned several times that auto financing is surged. I suppose I didn't talk so much about credit card debt. The reason why I didn't think that cost of money, interest rates entirely explained all the gloominess about this economy is, you know, the U.S. sells about five million houses a year. There's a couple million car leases a year. There are 170 million working Americans. There's 350 million working Americans. And so my thought was,

yes, Americans making big ticket purchases are relying on higher interest rates to make their budget work to buy those big ticket items, yes, but it's a tiny minority of the total number of Americans, and it's all the country that seems to be gloomy about this economy. So how do you guys think about the fact that the share of people who are actually participating in the real estate market or the auto market is not anything close to a majority of the country? And yet you're suggesting it explains a majority of the vibes gap. Yeah, so that's definitely something that we've spent a lot of time thinking about, and we have sort of two possible explanations. So first of all, in my case, obviously I haven't made any of, I'm not amongst the 3.5 million people or something who bought a house, but I'm very aware of how those interest rates have factored in.

So even though only 4 million people are buying houses, you and I both know a lot of people are scrolling through Zillow, thinking about what their mortgage payments are, thinking about what they possibly would be if they sold and they upgraded. So I think in that sense, there's a little bit of a larger group that are thinking about these big aspirational purchases. And then secondly, what I would say, and this was something that economists always thought of as a puzzle, we used to have, and the Federal Reserve Bank of Boston published a report on economic literacy. And one of the questions was, what do you think is going to happen to inflation when interest rates go up? And the correct answer was inflation should go down, but only 39.4% of the public got that answer correct, because a lot of people out there think as interest rates go up, that means inflation goes up,

that means prices go up. So even though it's a small group that are making these purchases, I think that the evidence is that folks really think that as these interest rates have been going up, actual measured inflation has also been going up as well. So I think that the role that interest rates play in people's lives is just a lot larger than what we otherwise would have thought. And the reason why economists, including myself, might have been blindsided is because interest rates have been so low for so long. And over that period, the share of purchases that we make on credit cards have gone up. The share of people who are getting loans have gone up. So when interest rates did start to increase from zero to five percent, a lot of people were really caught off guard

by that. The phenomenon of rising interest rates is a global phenomenon. And there have been some essays and articles, for example, published in the Financial Times that suggest that this gap between the hard and soft data is an American phenomenon. Now, if that's true, it means essentially that the vibe session is made in America, that there's no other country that is seeing this gap between the hard numbers that economists are looking at and the consumer sentiment stuff.

When you guys applied your new, updated, or not really updated, in a way, it's like retrograde, CPI measure to the current economy, excuse me, to economies around the world, could you explain that discrepancy as well? So when we looked around the world, we found that this was

not a unique American phenomenon. In all of the countries that we looked at in nine of the ten Western democracies that we included in our paper, there was a sentiment gap. Sentiment was lower than what we would have expected given measured inflation and unemployment. But when we sort of took the analogy from our paper, the way of thinking about how interest rates should have affected sentiment as well, and we looked around the world, it turned out those sentiment gaps were largest in areas that also included a large increase in interest rates. So although we weren't able to exactly reconstruct the CPI using the pre-1970 method in Luxembourg because we couldn't get Luxembourg mortgage rates, it was suggestive to us that this phenomenon

that we're seeing in the U.S. is also prevalent around the world. And some of the factors that had been suggested about why there are. is such a vibe session in the U.S., increased partisanship, Trumpism, lack of income equality, et cetera, the fact that the largest gaps that we found around the world were in Sweden and Germany sort of made us think a little bit harder about whether those were the key factors driving the vibe session in the U.S. So your analysis contains within it an implicit prediction, the prediction being that if interest rates go down, Americans' attitudes toward the economy will mechanically go up, right?

Have, do, I mean, I suppose we haven't exactly seen, you know, the Federal Reserve begin to cut interest rates, but, you know, mortgages have bounced around a little bit. Is there anything in the change of mortgage rates in the last few quarters or the change in, in auto financing rates in the last few quarters that make you confident that, in interest rates are a kind of lever on American consumer sentiment? Yeah, so I don't, you know, it's hard to make predictions, especially about the future. So I don't want to go too much into prognosticating. But what we have seen in the couple of months since our paper was written is as mortgage rates were ticking down in January and February, we saw the largest boosts in consumer sentiment that we've seen in the last

five years. There's still a vibe session, but it's not as large as we would have thought. So I think that was heartening to us, and it does underlie our point that as interest rates go down, if Chairman Powell, if and when they do start to cut rates, I do think that's going to do a lot to buoy not only the real economy, but also how people interpret the economy. And one place where, you know, that's going to be very apparent is going to be in the housing market. If and when rates are cut, there's going to be a lot more buying and selling, and some of the folks who sort of feel left out right now are going to feel better about the economy as they have the ability to buy housing. It also suggests, and you don't have to comment on this if you don't want to get into political prognostications, but it does

suggest that Jay Powell could play an outsized role in the 2024 election. If economic sentiment tends to determine people's opinion of the incumbent president, as I think historically it has, and economic sentiment is essentially a function of interest rates, and no individual in the world controls American interest rates more than Jay Powell. It certainly suggests that Jay Powell is an unbelievably important person to look to if he want to evaluate Biden's odds in November 24. You can decline to comment on that particular observation or not. No, I think it's a fascinating thing, and I think it is, you know, I think Chairman Powell right now has one of the hardest jobs that exists out there.

And I think this is something not new in American history, but it sort of was something that took a back seat, you know, as interest rates were so low and there was no interest rate policy sort of for the last 16 years, we sort of forgot about this. But if we actually think in the long term, you know, Jimmy Carter, in some sources blamed Paul Volker for his loss in the election in 1980. George Bush the first was quoted as saying, I reappointed Alan Greenspan. He disappointed me. So it used to be the case that, you know, in some sense, this is a reversion to what it's always been in the U.S., where interest rates really matter, and the Federal Reserve Chair has a lot of power on influencing the election. Judd Kramer, thank you very much. Thanks for having me. Thank you for listening. Plain English is produced by Devin Baroldi. One quick programming note, we in the month of March are going to move just temporarily to a

once-a-week publishing schedule. We'll be coming at you every Tuesday, no Friday episodes for the month of March. We got a little bit of extra work. We got a little bit of travel. This is just the best way to smooth out the time that we have to bring you consistent weekly entertainment. So one show a week in March, and we will be back to our regular two episode per week schedule in April.