One of the subjects which comes up regularly in any economics discussion or debate is inflation. Unfortunately it is a concept at which we are not very good at measuring as the concept is clear in theoretical terms but the various ways of measuring it all have pitfalls and flaws. For example the UK has two inflation measures the Consumer Price Index and the Retail Price Index which virtually always give different answers so we have to face the fact that one (or both) of them is wrong. Indeed if we look at the period both have been in existence (CPI is more recent) we see that there is a systematic difference which the Office for National Statistics describes thus.
Since its introduction, inflation (over a 12 month period) measured by the CPI has generally been lower than RPI inflation by an average of 0.9 percentage points.
If you consider that the inflation target for the UK is represented by the CPI being 2% this is actually quite a lot.
Why is the inflation target set at 2%?
If you take the view that inflation is a problem then you immediately have a conceptual issue with an inflation target of 2% which is simply,why not aim for zero inflation? After all if you have no issues with inflation you would not bother having a target. The Bank of England has a view on this and many of you may be particularly interested in the second sentence of it.
Although the objective of stable prices actually means no inflation, we do not aim for this. We prefer to have a moderate amount of inflation rather than zero inflation.
However one of its reasons for stating this is now way behind events.
having a positive inflation target allows real interest rates to be negative which might be a useful policy option when demand is weak
This one has not gone so well because we have seen negative real interest rates be quite high post credit crunch in the UK as inflation rose while base rates were cut but demand has remained weak. We have in essence flat-lined in economic terms for the past two years. So in reality the gain from this policy option appears rather weak right now.
Indeed an example that this is old era thinking comes in the explanatory section.
One consideration concerns the fact that interest rates cannot fall below zero
Oh dear! If we look at Switzerland we see that her bond yields are negative out to the five-year maturity and we see that in Germany they are negative from the 3 month to the 3 year maturity. If the world continues on its current downwards economic trajectory then such events will spread and I notice this morning that 3 month money in Japan looks as though it has gone negative too.
The other reason is below.
the measured rate of inflation tends to overstate the true inflation rate
Some price increases will reflect improvements in quality. For example, computers might include more features or have faster processors; cars might be more reliable.
Now I think that there is some truth in their first example but less in the second,after all cars were supposed to be more reliable in the first place! However this theory has led to the concept of hedonics where inflation indices are adjusted to allow for quality improvements. There are lots of problems with this with the most obvious being how do they know? Of course they do not. And we have the problem that inflation measures are aggregates and that downwards pressure on say computer prices might clash with upwards pressure on food prices and lead us to this famous retort to a member of the US Federal Reserve.
I cannot eat an i-pad!
This is an issue I consider to be very important as the moment you analyse it you realise that such an inflation index calculation discriminates against the poorer members of our society as they will be less likely to be able to afford products with “hedonic gains”. By contrast they will find themselves buying more of the goods where it does not apply such as food and housing. So as we stand the modern method of inflation collection is biased against them.
My suggestion is that as well as the headline inflation number we should be told the ones for the section where hedonics applies and the one where it does not.
The Bank of England scores something of an own goal
In its explanation of its position the Bank of England offers something of a straw man.
why not have an inflation target of 5% or 10%?
Unfortunately its policy seems to have been to target the lower end of that range in recent times!
Is inflation actually a problem?
John Maynard Keynes thought so.
By a continuing process of inflation governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.
This quote these days comes with a large degree of irony as so many policies presented as Keynesian have as part of their modus operandi exactly that! Indeed he may be the individual in history who has had his name put to more policies that he did not actually believe in than anyone else.
Those who are poor,those who are on fixed incomes and those who have savings are all likely to fearful of inflation as it will erode their financial position. Also it is something which enhances our political establishment as they can make promises and spend and then try to hide the real value of the debt that has been required to do this via inflation.
Indeed we see that what I regard as “the establishment” are responsible for quite a lot of inflationary pressure in the UK. Some of it is from the government such as higher charges from passports and some of it they sub-contract out such as higher rail fares. some comes under the disguise of what they consider to be a good idea such as “green levies” which are pushing fuel bills higher. Its a nice deal isn’t it when you can raise your income (taxes and levies) whilst simultaneously reducing the real value of your debt?
So as well as its effects on economic output via unpredictability and the costs of changing prices inflation is also a form of income redistribution. Except that one of the forms of redistribution is from rather than too the poor.
Does disinflation matter and how much?
I address this issue I believe it is an important issue for both economic theory and reality. Today’s numbers for producer prices in the UK exhibited both.
In the year to July 2012 the output price index for home sales of manufactured products rose 1.7 per cent
In the year to July 2012 the total input price index fell 2.4 per cent
Actually annual the rate of disinflation reduced for input prices this month but the issue remains.
Many observers including the Bank of England seem to panic over disinflation (base rates cut to 0.5% and Quantitative Easing) but are very blase about inflation. The response to fears of the former was extreme whereas the response to the reality of the latter was non-existent. My opinion is that whilst we are more uncomfortable with falling than rising prices there are circumstances where it is a good thing. Who wouldn’t rather pay £5 than £6 for something?
Central bankers fear disinflation because they have so far failed to defeat it when it has appeared. But if we look at Japan we see the disinflation has problems inbuilt in it but it has not led to the same problems as say high inflation has caused the UK in the past.
Everywhere one looks at inflation there are conceptual issues. Even at the beginning there is dispute as to whether it is rising prices or a rising money supply. I stick to the view that it is continuous rise in prices. But here there is the problem of telling a continuous rise from a relative price change. So we see a very familiar theme on this blog where economic theory finds itself in something of a minefield when reality hoves into view. Of course many economists prefer to ignore reality but I am not one of them.
Accordingly I think that inflation does matter but that one has to realise that our methods of measuring it are flawed. Indeed the credit crunch era is throwing up more examples of flaws in it as the concept of consumer price inflation targeting has to accept part of the blame. As we go forwards we find one more time that Johnny Nash was right.
There are more questions than answers
And the more I find out the less I know
Yeah, the more I find out the less I know
There is also the issue that changes to inflation indices always seem to involve a downwards element to them. For example the switch from RPI to CPI in the UK involved a reduction in the target from 2.5% to 2% which always implied that CPI would give a lower number for the same level of inflation. Actually I have always thought that this understated the gap. And above I have discussed hedonics.
Well in the UK we are going to get housing costs added to the CPI.Overall this is a good thing and an improvement but when I ask why now? I cannot avoid wondering if this is because house prices were rising then and are not now!