• Adjusting for inflation is tricky

    Abe Dunn, Scott Grosse, and Samuel Zuvekas are right: In many health care analyses, it is important to adjust for inflation, but there are numerous price indexes to choose from for the job. Which one should you use?

    Helpfully, the authors surveyed various measures of health care price inflation and provided guidance on which to use in various circumstances. Their paper also explains why price indexes differ.

    One important way they differ is the extent to which they incorporate changes in consumption patters. Laspeyres and Paasche type indexes hold fixed the quantities of goods and services consumed. The former fixes them in a base period and the latter fixes them in the current period. The only things that change in such indexes are prices. As such, they could misrepresent the actual impact of prices because people and institutions respond by changing how much of various goods and services they consume.

    Put it this way, if the price of a service in the index went from $1 per unit in the base period to $1 billion per unit in the current period, consumption would fall to zero. People would substitute something else that’s cheaper. Lasperyes and Paasche indexes would miss that trend, though in different ways. The former would show massive inflationary effects because the good is in the basket in the base period, while the latter would show no inflationary effects because the good is not in the basket in the current period.

    A Fisher index is the geometric mean of a Laspereys and a Paasche index. That makes it responsive to changes in consumption patterns, though not necessarily reflective of how they change period-by-period. A chained index, on the other hand, continuously updates consumption patterns.

    Another way price indexes differ is scope. Some indexes measure general price inflation, encompassing economic sectors beyond health care. Commonly used ones include the Gross Domestic Product (GDP), the Consumer Price Index—all urban consumers (CPI-U), and the Personal Consumption Expenditures (PCE) index. Some details:

    • GDP: A Fisher index that includes all sectors of economic activity (i.e., not just consumer spending). It is appropriate for adjusting for societal-level purchasing power changes.
    • CPI-U: A Laspeyres index that captures spending by urban consumers (i.e., excluding business and government spending, as well as consumption paid for on behalf of consumers by third parties). It is appropriate for adjusting for purchasing power changes in out-of-pocket spending.
    • PCE: A chained index that captures consumer spending, as well as that paid for by business, government and third parties on behalf of consumers. It is appropriate in the same circumstances as the CPI-U.

    Despite the differences in how they address consumption changes and scope, these three indexes of general price inflation track one another relatively closely, as shown in Figure 1.

    Other indexes measure only health care price inflation. These include the Personal Health Care (PHC) deflator, Personal Consumption Expenditures-health (PCE health), and the Medical Care CPI (MCPI).

    • PHC: A Fisher index that captures out-of-pocket and third-party health expenditures, excluding administration, research, and capital investment. It is appropriate for adjusting for general medical price changes. (Note, the National Health Expenditures (NHE) price index is an alternative that includes administration, research, and capital investment.)
    • PCE health: A chained index that is otherwise nearly identical to the PHC but has a longer history.
    • MCPI: A Laspeyres index designed to capture out-of-pocket health care spending, including that paid by individuals with private or Medicare Part B coverage. It is most appropriate for adjusting for out-of-pocket medical price changes.

    The chart below (the authors’ Figure 3) shows the historical trends for these three indexes, alongside the CPI-U. All start below the CPI-U and then fall into line with it by the late 2000s, with the exception of the MCPI, which rises above the CPI-U. That the MCPI has a different trend than the other medical price indexes is not surprising, since it is the only one of the three focused exclusively on out-of-pocket spending.

    Others indexes are even more narrow, measuring, for example, hospital price inflation overall or for different payers — the Medicare Hospital Producer Price Index (PPI), Medicaid Hospital PPI, Private Hospital PPI, Overall Hospital PPI, and Overall Hospital CPI. All five of these are shown in the author’s Figure 2, reproduced below. They exist for other services as well, not just hospital care.

    • PPI (overall and specific payers, disaggregated by service): A Laspeyres index of third-party payments appropriate for adjusting medical prices from specific payers for specific services.
    • CPI (overall and disaggregated by service): The same as the MCPI discussed above, but including components for different services. These are appropriate for adjusting for out-of-pocket spending.

    There are large differences in these indexes, as shown in Figure 2, reflecting differences in price growth in hospital care versus overall medical care and/or differences in growth from different payers or out-of-pocket spending. If you’re analyzing hospital payments, it’s very important to match the index to the type of analysis you’re doing and questions you’re addressing.

    The authors discuss many other nuances and issues, which are beyond the scope this post. They conclude with this advice:

    • To adjust health expenditures in terms of purchasing power, use the GDP implicit price deflator or overall PCE measure. The PCE measure is suitable for personal consumption. The GDP deflator is more appropriate for the societal perspective.
    • To adjust overall consumer out-of-pocket spending in terms of consumer purchasing power or out-of-pocket burden relative to income, the CPI-U can be used.
    • To convert average expenditures to care for a specific disease for price changes from 1 year to a different year, either the PHC deflator or the PCE health index can be used. Because of exclusions of some payers in its weights, the MCPI may not be appropriate to adjust all-payer expenditures or payments by employers, Medicaid, and Medicare Part A for medical inflation.
    • To convert average consumer out-of-pocket health care expenditures from 1 year to a different year, the MCPI can be used.
    • To adjust estimates of costs of inpatient services from different years, the PPI for inpatient services appears currently to be the best option.

    I’m certain many published analyses do not follow this guidance, including my own. In some cases, it may matter. In offering clear guidance on how to use health care price indexes, Dunn, Grosse, and Zuvekas have provided a valuable service.


  • AcademyHealth: Employer sponsored health insurance – an annual update

    Each year, around this time, the Kaiser Family Foundation releases its annual report on employer-sponsored health insurance. It’s always worth a read; this year is no exception.

    My take on it is worth a read, too. Go read that in my latest post over at the AcademyHealth blog!


  • A Two-Sided Inflation Argument

    In a post on today’s NY Times Economix blog, Casey Mulligan argues many sides of the inflation prediction debate (The Next Inflation: When, Why and So What?). After reviewing the arguments as to why government spending is not typically inflationary and why an increase in the monetary base can be, Mulligan suggests why the Fed may permit inflation: it will help boost housing prices and reduce the number of underwater mortgages. Mulligan writes that “inflation will likely be a deliberate choice to reduce the housing market’s drag on the wider economy.”

    This is a new variant on the “don’t worry about inflation” argument. It may be valid, though that is of course debatable. But I don’t like it. It basically says that the Fed could control inflation but may choose not to. Moreover, the inflation that the Fed allows could be beneficial. I don’t like it because it is a no lose perspective. If we get no inflation Mulligan can say, “See, I said inflation could be controlled.” If we get inflation Mulligan can say, “The Fed has chosen this course to help with home prices.”

    There’s no testable hypothesis in this point of view. It doesn’t really answer the questions when, why, and how much, unless you like the answers: “sometime later,” “because the Fed prefers it that way,” and “a little or a lot.”

  • Eye on Inflation

    This post originally appeared on The Finance Buff.

    Yes, another inflation post. If the economists keep blogging it, I’ll keep linking to their stuff. We’ll see in a few years who got it right. I’ll have the records!

    I predict more debate, followed by some “I told you so” gloating, and then we’ll all forget about it until the next blast of fiscal and monetary stimulus in ??? years.

  • Inflation Watch

    This post originally appeared on The Finance Buff.

    This is the next of my occasional posts on inflation. By and large, many economists are not worried about inflation now, though there is, of course, some debate on the matter. In a June 10, 2009 NY Times Economix post “Inflation and Government Spending“, Casey Mulligan summarizes research that suggests government non-war spending is not inflationary. To quote the Economix post,

    Our study found significant positive correlations between inflation and government spending only in cases when military spending grew — as it does during wartime. But the government spending growth we have seen in 2008 and 2009 comes from the nonmilitary part of the budget.

    Taxpayers will suffer as a result of the federal government’s recent and excessive spending, but a great many taxpayers around the world have faced similar liabilities, while nonetheless experiencing modest or low inflation.

    I have no opinion as to whether or not we’ll see high inflation as a result of recent fiscal and monetary policy. As I come across opinions expressed by economists on the matter I’ll post them. Feel free to draw my attention to them if you see any yourself.

  • What Inflation Means for Social Security and Medicare

    This post originally appeared on The Finance Buff.

    The Congressional Budget Office (CBO) Director’s Blog is one of my favorite ways to stay current with issues that affect the financing of federal programs. The 22 April 2009 post explained why CBO projects no cost of living adjustments (COLA) for Social Security in 2010 through 2012 and the implications for the Social Security taxable maximum. A follow-up post on 23 April 2009 explained the implications for Medicare Part B premiums. Below I summarize what the director communicated in those two posts.

    The Social Security COLA is based on the consumer price index for urban wage earners (CPI-W). Social Security benefits cannot be reduced and they will only increase if the CPI-W climbs to new highs. CBO projects that for the next three years the CPI-W will stay below the value it attained toward the end of 2008. If this projection holds, Social Security benefits would remain at their 2009 values for the three years 2010-2012. Benefits provided by other federal programs with COLAs tied to that of Social Security would also see no increase in these years (includes civil service and military retirement, as well as veterans’ compensation and pensions benefits).

    That’s the bad news for those receiving Social Security and other federal retirement benefits. The good news for wage earners is that the maximum amount of wages subject to Social Security payroll tax (the so-called “taxable maximum”) would stay fixed too because it only rises as COLAs rise. The taxable maximum for 2009 (and projected for 2010-2012) is $106,800 (historical values here).

    There is, however, good news for some Medicare beneficiaries. Since 1996 the Medicare Part B premium for most beneficiaries has been set at 25% of the cost of Part B coverage. In 2009 the Part B premium is $96.40(*) per month (see this Congressional Research Service report for past premium values). For some Medicare beneficiaries this 2009 value would hold steady through 2012 if, as CBO projects, the CPI-W stays below its peak over that period. This “hold harmless” provision applies to 75% of Medicare beneficiaries who have their Part B premium withheld from their Social Security check. The hold harmless rule is that the Social Security check after Medicare withholding cannot decrease. That limits the Medicare withholding increase to be no larger than the Social Security COLA. No COLA, no additional Part B premium.

    But, this situation does not apply to the quarter of Medicare beneficiaries who fall into any of the following categories: (1) new enrollees in Part B, (2) enrollees who pay an income-related premium, or (3) those who do not have the Part B premium withheld from their Social Security check (most of whom have their premiums paid by Medicaid).

    These beneficiaries (or, through Medicaid, their state governments) would be hit with a double whammy. Not only would they not benefit from the zero COLA (in the sense of their Part B premiums holding constant) but their premiums would rise an additional amount to compensate for the revenue lost due to the other 75% of of premiums that would stay flat. The increase would be nearly four times larger than it would be if everyone’s premiums went up. CBO expects the monthly premium for these unlucky beneficiaries to be $119 in 2010, $123 in 2011, and $128 in 2012, while premiums for the hold harmless beneficiaries would stay at $96.40 per month (*).

    Medicare prescription drug plan premiums are not subject to a hold harmless rule for anyone. If they go up, as they are expected to do, beneficiaries pay the higher premium whether automatically deducted from their social security check or not. Therefore, the six million or so Medicare beneficiaries with drug premiums deducted from their social security check will see their net social security payment decrease.

    Medicare is many things and one of them is a complicated and confusing mess.

    (*) As confirmed by an e-mail exchange with CBO staff, all premium amounts reported by CBO and, thus, in this post apply to individuals and couples who do not face income-related premium adjustments. For those with sufficiently high incomes premiums would be even higher.  (Hat tip: bob u. of the Bogleheads Investment Forum.)

  • Is Inflation Under Control?

    This post originally appeared on The Finance Buff.

    There has been a lot written lately about the possible effect of Federal Reserve activities on the inflation rate.

    One person I trust on this topic is economics professor James Hamilton (UC San Diego). He tracks the Fed’s balance sheet pretty carefully and has put out an exceptional post that explains its recent activities and the extent to which they’re inflationary. He followed up that post with another good one and I’m sure there will be more.

    I encourage you to read Hamilton’s posts on this topic. In summary, in the above-referenced posts he shows that very few of the dollars the Fed has pumped out recently have entered circulation. Banks are sitting on most of it because they’re not lending. The Treasury Department soaked up some more by issuing additional US debt. Meanwhile, what the Fed has mostly been doing is swapping its Treasury holdings for other types of assets.

    In the vernacular of macroeconomics, the Fed has been utilizing qualitative easing. On paper they have also been engaging in quantitative easing. Since the funds have ended up in bank reserve accounts or in Treasury accounts and not in the hands of the citizenry, effectively the amount of quantitative easing has been small so far.

    The tricky bit down the road is how quickly the Fed can soak up dollars if and when inflation shows up. To facilitate doing so, the Fed wants to hold assets that would be in high demand during times of inflation. This is why Hamilton recommends the Fed buy TIPS.

    Nevertheless, he says that inflationary pressures remain under control at the moment, “but stay tuned.”

    April 12, 2009 update: How the Fed induces banks to hold on to reserves above the required minimum is explained clearly in this post by Susan Woodward and Robert Hall.