The Economist’s Inflation expectations primer
Posted June 30, 2008on:
The Economist has an excellent piece on inflation expectations (*) (ht Anti-dismal and the Economist blog). In it they mention some of the difficulties of using the inflation expectation measures as a gauge of inflation, namely:
- The problem with survey measures: Consumer often mis-interpret inflation, and take increases in the price of certain goods (eg fuel and food) as inflation – ignoring the reduction in the price of other things (appliances).
- The problem with market measures: Perceived risk also drives the same measures – implying that there can be biases.
Now I agree in large parts with what they have said, however I think they “over-sold” the first case. As the article says, the focus on inflation expectations is because of fears of a “wage-price spiral” – as a result, if employees can ask for wage increases based on their expectation of inflation, then it doesn’t matter if what they expect inflation to be the same as measured inflation – they will still drive cost pressures up, driving up self-fulfilling inflation.
That is what concerns me so much about the 5.8% increase in the GDP deflator on Friday – this is the increase in prices taking account of peoples change in spending, people have seen prices rising by this amount and will want to be compensated for it.
In some sense, I would be more concerned about how me measure inflation than in how consumers mis-interpret it. Yes, our inflation measures are being knocked down by ever cheaper imports from China – however, this isn’t a reduction in true inflationary pressures (the kind that we should care about), this is just a reduction in the relative price of appliances.
If our inflation measure changes because of relative price shifts then we can’t take that as a sign of better or worse inflationary outcomes – as it is solely the optimal market response to this change in economic fundamentals!
Also I am concerned that the Economist said that long-term measure of inflation are the most important. To an economist this would immediately feel write – as the long run is when everything settles down. However, the reason that inflation is a problem is because of the stick nature of prices (namely wages). The appropriate inflation expectations period should be 1-2 contract setting periods out – as this captures the inflationary pressures that will be prices into fixed prices, which in itself helps to perpetuate price growth. As a result, I think they miss the boat a little on the consumer survey’s.
As long as we believe people understand that inflation is an increase in the general price level (something I don’t think most people fully understand when answering these survey’s) then these questions may give a better understanding of inflationary pressures.
Personally, I think it would be better to ask people what sort of pay rise they are going to go for (realising that they probably won’t be able to negotiate it and will be exaggerating in the first place) in order to get an idea of where these self-perpetuating inflationary pressure are at.