Why Official Inflation Measures Don’t Work
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Modern macroeconomics has made price stability the primary objective of monetary policy. It is assumed that central banks can ensure price stability by skillfully managing the money supply, thereby creating the conditions for economic growth and prosperity.
In order to provide a safety buffer against the dreaded price deflation, central banks around the world try to generate a positive but moderate rate of price inflation. Price stability thus means a stable rate of inflation. The prices of goods and services should on average rise slowly at a constant rate over the medium and long term. In the eurozone, the aim is to achieve a price inflation rate close to but below 2 percent.
However, it cannot be denied that measuring a general price level and its rate of change is associated with major problems. The formal inflation target of the central banks must be operationalized in practice. It is therefore necessary to determine which prices are targeted and how they are to be summarized in a weighted average.
The Harmonized Index of Consumer Prices
The member states of the eurozone have agreed on a standardized procedure for measuring inflation. The Harmonized Index of Consumer Prices (HICP) is the operationalized target variable of monetary policy. The calculation of the HICP is relatively complex,1 as attempts are made to eliminate possible distortions in the measurement of inflation by means of elaborate procedures and estimates. However, it is highly questionable whether this is successful. In the following, I would like to take a closer look at two important sources of bias.
The HICP consists of twelve subindices2 which group together different classes of goods. Each of the subindices consists of different subcategories, which are again subdivided until the individual prices of certain goods and services are reached at the lowest level. These unit prices must be adequately weighted for the calculation of the index. The principle is that goods and services on which a large proportion of income is spent must be given a higher weighting than those goods and services that are purchased only very sporadically and in small quantities. Formally, therefore, the weights are determined by the real turnover shares. In Germany, for example, the weight of the subindex “Food and non-alcoholic beverages” (CP01) currently stands at 11.3 percent, which means that the average German household is assumed to spend 11.3 percent of its consumption expenditure on goods in this category. By comparison, the weight for “Alcoholic beverages, tobacco and narcotics” (CP02) is 4.2 percent.
As consumption decisions are constantly changing, the weighting scheme applied may lead to distortions in the measurement of inflation. In the 1990s, for example, the Boskin Commission found a systematic overestimation of price inflation rates in the US of 0.4 percentage points per year.3 The cause of the distortion was the systematic substitution behavior of households.
The argument is as follows. Let us assume a base year with a given weighting scheme for all individual goods and services included in the index. This weighting scheme reflects the consumption behavior of households in the base year. This behavior changes over time, partly because prices for some goods rise faster than for others. Over time, households will tend to buy less of those goods whose prices rise faster. And they will instead buy more of other goods that have remained relatively cheap. Households will thus substitute goods with a relatively high rate of inflation for goods with a relatively low rate of inflation. If the weighting scheme is not changed, an upward distortion of the measured price inflation will result. One would overestimate price inflation.
Let me illustrate this with a simple example. Imagine a price index for soft drinks. The purchase prices of Coke and Pepsi are included in the index at 50 percent each, because on average households spend proportionally the same amount on both beverages. Assume that over a certain period of time the price of Pepsi increases by 5 percent per year. The price of Coke increases by only 1 percent annually. If the weighting is not changed, the overall inflation rate is 3 percent. In fact, however, the consumption behavior has shifted due to the different inflation rates. On average, households now buy more Coke and less Pepsi. Let us assume that households now spe
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