US inflation rose from 3.0% year-on-year in June to 3.2% in July according to headline CPI data published by the Bureau of Labor Statistics (BLS). While the core index declined from 4.8% year-on-year to 4.7%, both measures remain above the Fed’s 2% inflation objective (see Chart 1).
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US HICP inflation
US inflation remains above the Federal Reserve’s 2% target, with contributions from the shelter component slowing its decline. However, US consumer price indices treat the shelter component differently to the euro area’s Harmonised Index of Consumer Prices (HICP). In this Macro Flash Note, Economist Sam Jochim looks at what US inflation would be if it followed the HICP methodology.
Chart 1. US CPI inflation (% change, year-on-year)
Source: Refinitiv and EFGAM calculations. Data as at 24 August 2023.
In the US, the weight of the shelter component in the CPI is around 35% for the headline index and 44% for the core index.1 The shelter component itself is split into rent of primary residence and owners’ equivalent rent (OER) of residence. The latter accounts for over 70% of the shelter component.
However, the inclusion of OER is controversial. The US includes it to capture the idea that owning a home provides the occupant with shelter, a service they would otherwise have to pay for.2 In the euro area, HICP excludes owner-occupied housing expenses since housing is considered a capital good. Housing expenditures are therefore seen as investments and out of scope of a consumer price index.
It is interesting to look at an experimental US HICP index produced by the BLS which excludes all owner expenses (see Chart 2).
Chart 2. US HICP inflation (% change, year-on-year)
Source: BLS and EFGAM calculations. Data as at 24 August 2023.
Using the HICP methodology, US headline inflation fell below 2% in June, while core inflation dropped to 2% in July. This raises an important point: that US CPI inflation remains above 2% largely reflects the treatment of the owners’ expenses component. Since OER is slow-moving and not an expenditure a consumer pays out of income, the Fed could increase the risk of overtightening monetary policy if it places too much weight on the headline or core CPI indices.
It is notable then that the Fed focuses on PCE, and not CPI, inflation. While PCE inflation still includes OER, its weight is much lower than in the CPI. One can also remove OER from PCE inflation and reweight the remaining components to see its impact (see Chart 3).
Chart 3. US PCE inflation (% change, year-on-year)
Source: Refinitiv and EFGAM calculations. Data as at 24 August 2023.
Doing so highlights that both headline and core measures of PCE would be below their current levels if OER were excluded. In June, headline and core PCE inflation were 3.0% and 4.1% year-on-year respectively, while excluding OER they were 2.3% and 2.6% year-on-year respectively. Although they would still have been above the Fed’s 2% inflation objective in June, the analysis emphasises the point that the Fed could increase the risk of overtightening monetary policy if it focuses on headline or core PCE inflation without considering the impact of OER.
Looking at core inflation in the US using PCE, PCE ex. OER, CPI and HICP is also revealing (see Chart 4). The level of core inflation increases as the weight of OER increases.
Chart 4. US core inflation (% change, year-on-year)
Source: BLS, Refinitiv and EFGAM calculations. Data as at 24 August 2023.
It should also be noted that there are other differences between euro area and US HICP. In the euro area, HICP inflation uses data sampled from the entire population whereas in in the US, CPI data are taken only from the urban population i.e., excluding price data from rural areas. Furthermore, since the US HICP is produced outside the scope of the official production system, the data are more vulnerable to calculation errors than the official CPI indices.3
In addition, there are differences between consumption patterns that can result in different behaviour of indices even when an identical methodology is used. For example, in the US, consumers pay for a larger portion of healthcare than in the euro area, where healthcare is often provided by government programs. Since government programs are not accounted for in HICP inflation, healthcare has a much larger weight in US HICP than in euro area HICP.
To conclude, it is interesting to compute what US inflation would look like were the shelter component treated the same as in the euro area. Using this methodology, US headline CPI inflation would be below 2% and core inflation would be at the 2% level. Excluding OER from PCE inflation also lowers the year-on-year rate of inflation, though not below the Fed’s 2% objective. This highlights the increased risk of overtightening monetary policy if too much weight is placed on OER, which is an imputed cost rather than one a consumer pays.
1 https://go.pardot.com/e/931253/news-release-cpi-t01-htm/3hnwg/251556697?h=wVomJ0PQDs6FTyBSqTDhy0-6wq7J_D9bwt17GPgvs4E
2 ‘Comparing U.S. and European inflation: the CPI and the HICP’: https://go.pardot.com/e/931253/opub-mlr-2006-05-art3full-pdf/3hnwk/251556697?h=wVomJ0PQDs6FTyBSqTDhy0-6wq7J_D9bwt17GPgvs4E
3 See also ’Comparing U.S. and European inflation: the CPI and the HICP’