I haven't seen anything of note written about the probable effect of the implementation of the Affordable Care Act (ACA, or "Obamacare") on Medical Care CPI. This is probably because the calculation of Medical Care inflation in the CPI is confusing to many and because the direct effects of the ACA are still speculative at this point. But this is a potentially dangerous oversight since Medical Care is 7.2% of the CPI, and is after all the part that has recently been dragging Core CPI and Core PCE lower because of its unusual weakness.

Even if one cannot fathom the details, we know that the ACA will add volatility to the measurement of medical care inflation, and with measured medical care inflation so low presently, relative to historical trends, this implies mostly upside risk to prices. The following chart (Source: Enduring Investments) shows the rolling annual increase in Medical Care CPI, along with core CPI.

The most generous interpretation of this chart is that the ACA was already having an impact on holding down medical care prices prior to its implementation, although this ignores the known effect of the sequester on medical care inflation outturns: the sequester slowed Medicare payments to providers, and this had the effect of lowering measured medical care inflation temporarily. Another cavalierly optimistic interpretation might be to suggest the possibility that the secular outperformance of medical care inflation relative to broad inflation is coming to an end.

While the actual economic effect of the ACA will only be determined over a long period of time as the actual rules and the free market response become more clear, I think that the effects of the ACA on the measurement of medical care inflation, at least for several years, will have the effect of pushing medical care inflation higher. The reasons for this are less about the question of whether disrupting the private insurance industry and price system is likely to create overall gains in efficiency in delivering health care, and hence lower prices (I doubt it), and more about the somewhat arcane way that medical care costs are accounted for in the Consumer Price Index.

Accounting for changes in the cost of medical care is a very challenging problem for a number of reasons. One of these reasons is that changes in medical care prices, like all price changes, reflect both inflation and the possible change in the quality of the delivered product. A mundane example of this problem outside of medical care is when the size of a candy bar increases 20% and the price of the bar rises 25%. Clearly, in such a case there isn't 25% inflation in the cost of a candy bar, because the consumer is getting 20% more candy in the bargain. That is a simple quality adjustment, and the BLS regularly makes these changes (more often, of course, the candy bar shrinks so that the quality adjustment increases measured inflation rather than the other way around!). More problematic and controversial are when the quality change is more subjective, such as when a car adds chrome wheel rims or a disk drive doubles in size, or when the BLS makes changes for the aging of the housing stock. Nevertheless, the BLS has sophisticated models for making these adjustments with the least amount of subjective evaluation possible.

How, though, does one measure the improvement in the quality of medical care when the whole course of treatment for a given condition may change? The service being provided, after all, isn't "one MRI image" but "improved leg function as the result of surgery done with the benefit of improved MRI imaging." This is a continued challenge for the BLS and one that the Bureau has spent many resources researching over the last few years.

So one problem that the BLS faces is that the price index does not necessarily measure quality improvements well. Another problem is that the Consumer Price Index is supposed to measure costs to consumers, and few consumers pay directly for their medical care but rather for insurance; moreover, the government itself pays for much medical care through Medicare and other programs which have no direct cost (at least, in a direct financial sense as opposed to an economic sense) to the consumer of medical care. For many consumers, too, their employer picks up part of the cost of insurance.

The BLS therefore measures medical care not by looking at the cost of insurance but by looking at what insurance companies pay for the medical care on behalf of the consumers, and then separately accounting for the insurance company profit as a different consumer item. Government purchases of health care are entirely outside of the consumer price index since the government is not a "consumer!" The employer-paid portion of health care insurance is also excluded since a company is also not a consumer.

So what does this mean for the effects of the ACA on the cost of medical care? I can see several likely effects:

1. Because the BLS measures the prices being paid by insurance companies to doctors, rather than insurance costs, the sharp increases in insurance costs due to the transition to the health care exchanges dictated by the ACA may not be immediately reflected in the price index for medical care. However, it is also possible that doctors and hospitals may take advantage of the confusion by changing their prices at this time and blaming the increase on the increased burdens of the ACA. Prescription drugs, too, may see price increases for this reason. The outcome of this part of the transition is probably indeterminate on medical care inflation in the short term, but it clearly increases the range of possible outcomes. If provider price increases happen quickly even though new insurance policies will only gradually be taken, then medical care inflation might increase quickly in the short run. But the opposite might also happen, so that consumers face higher insurance costs but medical care inflation does not reflect this.

2. Much more problematic is a composition effect that will affect the relative health of the patients that doctors will be treating, almost immediately. Many Americans have just lost their private health insurance. Faced with this, consumers who are relatively healthy are likely to decrease their doctor visits relative to comparatively unhealthy patients because of the increased out-of-pocket cost of going to a doctor. Unhealthy patients have less of an option to decrease consumption of medical care in response to higher costs, and indeed some very unhealthy patients have seen their costs decline due to the ACA (which was, after all, the point: not affordable care for all, but affordable care for those who were finding health care very expensive partly because they needed a lot of it). Because the BLS measures health care costs at the provider level, this could increase measured health care inflation quickly because of increased utilization of more-expensive treatment options.

3. The fact that the BLS only considers the employee-paid part of company health care plans also has very interesting implications under the chaotic transition to the ACA. When an employer pays less of the premium for a corporate plan, the employee pays a higher price (and feels inflation) even if the overall premium doesn't change. But this increases the weight of Medical Care in the consumer's consumption basket, so that the 7.2% weight in the CPI will increase, and probably substantially, over the next couple of years. Consider the previous chart, illustrating that medical care inflation has outstripped broader inflation indices for at least the last three or four decades. To the extent this continues, a higher weight of medical care implies a higher overall level of inflation.

4. In general, the ACA creates uncertainty among service providers in the health care industry. A typical reaction of suppliers facing uncertainty in any industry is to raise prices in order to increase the margin for error (in much the same way that asset prices tend to be lower when investors feel less safe and thus must build a margin of safety into the bid price). While not strictly inflation since the cushion would not increase each year, it would tend to increase measured inflation over the medium term.

It is very difficult to evaluate the size and timing of each of these effects, but it is important to note that while some of the effects are indeterminate (such as #1 above), there are no effects I can discern that would tend to decrease measured inflation of medical care. Consequently, I expect that Medical Care inflation - which has been, I have previously mentioned, a key source of the weakness in core inflation compared to median inflation - is likely to rise appreciably over the next year. Note that this is likely to be the case even if the ACA actually succeeds in lowering the aggregate economic cost of healthcare (about which fact I are skeptical) because the way the BLS measures medical care inflation is likely to cause increases in this index.

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