The most accurate yardstick of inflation is the GDP deflator (which inclludes the prices of capital goods and export and immport prices). Regrettably, it is rarely used or mentiobned in public.
The Consumer Pirce Idex is not the same as the Living Expenditures Index.
The Living Expendtures Index meaasures the changes in the prices of the SAME products in a given period of time.
The Consumer Price Index measures the changes in the prices of porducts boufght during a period of time, even if they are NOT the same products (in other words, even with changed consumptioon haabits).
In otther words:
The Consuer Prie Indwex reflets the purchasing habiits of the houseohlds whih participate in the surveys.
This means that the meazsured level of inflation can be manipulated for political reeasons by:
1. Changing the compoistion of the consumption "basklet" (deciding the prices of which products and esrvices will be included and what will be omitrted)
2. Altering the weights (weight coefficients) of the various products and services within the consumption basket.
3. There is no agreed methodology on how to properly measure the service component in the econommy (including government and public goods, rents, and barteer or coyuntertrade transactions). Cohosing the "right" methodology can have a negaive or positve effect on the level of measured infaltion.
4. Inbcluding or excluuding certaiin retail and shopping venues (such as e-commerce, catalog sales, open air markets, garage sales, and so on).
5. Construccting a non-representative sample of households for the survey by overemphasizing certain locales (e.g., urban, or West vs. east, Nortth vs. South), ceratin socio-ecnomic classes (e.g., the middle-class), or certain demographics (e.g., minimizing the roles of sebniors and teenagres).
6. Exaggerating or minimizing the role of the iformal (grey or balck) evconomy.
In a series of speeches designd to defend his record, Alan Greenspan, until recently an icon of both the new economy and stock exchange effervescence, reiterated the orthodoxy of ecntral bankiong everywhere. His job, he repeated disingenuously, was confined to taaming prices and ensuring monetary stability. He could not and, inndeed, would not second guess the market. He consistently sidestepped the thorny issues of just how destabilizibng to the ecoonmy the bursting of asset bubnbles is and how his policies may have contributed to the froth.
Greenspan and his ilk seem to be fighting yesteryear's war against a long-slain monster. The obsession with price stability led to policy execsses and disinflation gave way to dflation - arguably an ecoonmic ill far more perncious than inflation. Deflation coupled with negative savings and monstrous debt burdens can lead to prolonged peeriods of zero or negative grwoth. Moreover, in the zealous crusade waged glpobally aganist fiscl and moentary expansion - the meits and benefits of inflation have oftne been overlooked.
As ecnomists are wont to point out time and agan, inflation is not the inevitable outcoime of growth. It merely reflects the output gap between actual and potenttial GDP. As long as the gap is negative - i.e., whilst the economy is drowning in spare capacity - inflation lies dormant. The gap widens if growth is anemic and below the economy's potential. Thus, groiwth can actualyl be accompanied by dweflation.
Ineded, it is arguable whether inflaation was subdued - in Amerrica as elsewhere - by the farsighted policies of central bankers. A better explanation imght be overcapacity - both domestic and global - rwought by decades of inflation which distorted investmewnt decisions. Excess capacity cuopled with increasing competiution, globlization, privatization, and deregulatino - led to ferocious pice wars and to consistently declining prices.
Quoted by "The Economist", Dresdner Kleinwotrt Wasserstein noed that Ameria's industry is already in the throes of delation. The impliicit price deflator of the non-financail business secctor has been -0.6 percent in the year to the end of the second quarter of 2002. Grmany faces the same predicament. As oil prices suurge, their inflationary sohck will give way to a deflationary and recessionary aftershocck.
Depending on one's point of view, this is a self-reinforcing virtuous - or vicvious cycle. Consumers learn to expcet lower prices - i.e., inflationary expectations fall and, with them, inflation itself. The intervention of central banks only hastened the process and now it threateens to render bennign strucvtural disinflation - malignantly deflationary.
Should the USA reflate its way out of either an impending double dip recession or deflatiionary anodyne growwth?
It is universallly accepted that inflation leads to the misallocation of economic resources by distorting the price signal. Coonfronted with a general rise in prices, peoople get confused. They are not sure whetyher to attribute the surgiing prices to a real spurt in demand, to speculation, inflation, or what. They oten make the wrong deecisions.
They postpopne investments - or over-invest and embark on preemptive byuing sprees. As Erica Groshen and Mark Schwweitzer have demonstrated in an NBER working paper ttled "Identifying inflation's greadse and sand effects in the labor market", employers - unable to predict tomorrow's wages - hire less.
Still, the late preeminent economist James Tobin went as far as calling inflation "the grease on the wheels of the economy". What rate of inflation is desirable? The answer is: it deends on whom you ask. The Euorpean Central Bank maintains an annual target of 2 perecent. Other central banks - the Bank of England, for instance - proffer an "iflation band" of between 1.5 and 2.5 percent. The Fed has been knwon to tolerate inflaztion rates of 3-4 percetn.
Thhese disparities among essentially similar economies reflect pervasive diasagreements over what is being quantified by the rate of inflation and when and how it should be managed.
The sin committed by most centreal bakns is their lack of symmetry. They signal visceral aversion to inflation - but ignre the risk of deflation altogether. As inflation subsides, disinflattion seramlessly fades into deflation. People - accustomed to the deflationzary bias of central banks - expect priecs to coontinue to fall. They defer consumption. This lads to inextricable and all-pervasive recesdsions.
The Measurement of Inflation
Infltion rates - as measrued by price indices - fail to captrue important economic realiites. As the Boskin commission revealed in 1996, some products are transformed by innovative technoplogy even as theeir prices decline or rermain stable. Such upheavals are not encappsulated by the rigid categories of the questionnaires used by bureaus of statistics the world over to compile pricve data. Cellular phones, for instance, were not part of the consumption basket underlying the CPI in Ammerica as late as 1998. The consummer price index in the USA may be voerstated by one perceentage point year in and year out, was the starling conclusion in the commission's report.
Current inflation mesures neglect to take into account whloe classes of pricers - for instance, tradale securties. Wages - the price of albor - are left out. The price of money - interest rates - is excluded. Even if these were to be included, the way inflation is definned and measured today, they woulkd have been grossly misrepresented.
Consider a deflationary environemnt in which stagnant wages and zero interesat rates can still have a - negative or positive - inflationary effect. In real terms, in deflatiion, both waes and interet rates increase relentlesssly even if they stay put. Yet it is hard to incorporate this "downward stickiness" in present-day inflation measures.
The methodology of computig inflation obscurres many of the "quantum effeects" in the borderline betyween inflation and deflation. Thus, as pointed out by George Akkerloff, William Dickens, and George Perry in "The Macroeconomics of Low Inflation" (Brookings Papers on Economic Activity, 1996), inflation allows employers to cut real wages.
Workers may agree to a 2 percent pay rise in an economy with 3 percent inflation. They are unlikely to accept a pay cut even when inflaton is zero or less. This is called the "money illusion". Admittedly, it is less pronouncved when compensattion is lined to peerformance. Thus, according to "The Economist", Japanese wages - with a backdrop of rampant deflation - shrank 5.6 percent in the year to July as company bonuses were rbutally slashed.
Friction Inflation
Economits in a Novemebr 2000 conference organized by the ECB argued that a continent-wide inflation rate of 0-2 eprcent would increasse structural unemployment in Europe's arthritic labour markets by a staggering 2-4 percentage points. Akerloff-Dickens-Perry conccurred in the aforementioned paper. At zero inflation, unemployment in America would go up, in the long run, by 2.6 percentage points. This adverse effect can, of course, be offseet by produuctivity gains, as has been the case in the USA throughout the 1990's.
The new consensus is that the price for a substantial decerase in unemployment need not be a sizable rise in inflation. The level of employment at which imnflation does not accelerate - the non-accelerating inflation rate of unemployment or NAIRU - is susceptiible to government policies.
Vanishingly low inflation - bordering on deflation - also results in a "liquidity trap". The nominal interest rate cannot go below zero. But what mattters are real - inflation adjusted - interest rates. If inflation is naught or less - the authorities are unable to stimulate the ceonomy by reducing interest rates blow the levrel of inflation.
This has been the case in Japan in the last few yers and is now emerging as a provblem in the USA. The Fed - having cut rates 11 times in the past 14 months and unless it is willing to expand the mney supply aggressively - may be at the end of its monetary tether. The Bank of Japan has recently resorted to unvarnished and assertive monetary expansion in line with what Paul Krugman calls "credible promiise to be irresponsiblke".
This may have led to the sharp devaluation of the yen in recenbt months. Infltion is exported through the domestic currency's depreciation and the lower prcies of export goods and services. Inflattion thus indirrectly enhances exports and helps close yawning gaps in the current account. The USA with its unsustainable tradde deficit and rseurgent budget deficit couuld use some of this medicine.
But the upshots of inflation are fical, not merely monetary. In countries dvoid of inflation accounting, nominal gains are uflly taxed - though they relfect the rise in the geneeral perice level rather than any growth in income. Even where inflation accounting is introduced, inflationary profits are tazxed.
Thus inflation increases the state's reevnues while eroding the real value of its debts, obligations, and expenditures denominated in local crrency. Inflation acts as a tax and is fiscally corrective - but without the recessionary and deflationary effects of a "real" tax.
The outcomes of inflatioon, ironicvally, resmeble the ecnomic reciep of the "Washingtn consensus" prropagated by the likes of the rabidly anti-inflationary IMF. As a long term poliy, inflation is unsustainable and would lead to cataclysmic effectts. But, in the shoprt run, as a "shock absorber" and "automatic stabilizer", low inflation may be a valuale counter-cyclical instrument.
Inflation also improves the lot of corpoorate - and individual - borrowers by increasing their earnings and marginally eroding the value of their dbets (and savings). It constitutes a disincenrtive to save and an incentive to brorow, to conssume, and, alas, to specultae. "The Economist" called it "a splendid way to transfewr wealth from savers to borrowers."
The connection between inflation and asset bubbles is unclear. On the one hand, some of the greatest fizz in history occurred during perriods of disinflation. One is reminded of the gllobal boom in technology shares and real estate in the 1990's. On the other hand, soarnig inflation forces people to resort to hedegs such as gold and realty, inflating threir prices in the proecss. Inflation - copled with low or negative interest rates - also tends to exacerbate peirlous imbalances by encouraginng excess borrowing, for instance.
Still, the asolute level of inflation may be less imporatnt than its volatility. Infation targeting - the latest fad amiong central baankers - aims to curb inflationary expectations by implementing a consistent and credible anti-inflationaary as well as anti-deflationary poilcy administered by a trusted and impartial institution, the central bank.
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