Price indicies: A discussion
Posted July 25, 2008on:
Note: Other posts in this discussion are available under the tag “inflation debate“.
With the trade-off between inflation and other things behind us, and a justification for inflation targeting, we have a good base to discuss current activity and issues. The aim is to now discuss other methods of fighting inflation – however, before discussing this I think it is important to discuss another technical issue: How do we measure inflation?
This is both an incredibly important issue, and a highly contentious one. While I was going to write a long post on this, Dr Chinn at Econobrowser beat me to it (and also did an infinitely better job than I could have 😉 ). Dr Chinn discusses how we use the CPI to measure inflation, and the limitations of this measure (especially in terms of individuals expectations of what inflation is!). As a result, he covered all my main points 🙂
However, I will write some additional stuff anyway 😉
One thing I would add is that the annual % change in the CPI does not measure inflation – instead it measures the growth in an index that represents the general price level, over two points in time that are 12 months apart. Inflation itself is the trend rate of growth in the general price level.
It is this trend that the Reserve Bank needs to keep control of, and as a result any way of measuring this trend would be lovely.
Now this does not make the annual % change in the CPI a useless thing to keep track of – it just means that we have to understand what it means when we look at this index. For example, an exogenous increase in petrol prices will increase the CPI suddenly – but this does not imply that it is inflationary. Take this impulse-response graph from a simple (and extremely dodgy) VAR model:
What this shows us is that the initial shock to petrol prices does lead to an increase in annual growth in the CPI. However, over time CPI growth falls below where it would have been (if the shock had not happened) as the higher petrol prices slow domestic economic activity and increases the deflationary impact stemming from the output gap (Note: This is based on post 1996 data – as a result it does not include any of the episodes of cost push based inflation – which is why we get such a strong result).
This tells us that it is important to think about how shocks influence annual growth in the CPI now and in the future, in order to get an idea of true “inflationary pressures”. As a result, we shouldn’t be criticizing the Reserve Bank for the CPI rising at more than 3% right now – but we should be a bit concerned about the fact that the trend in price growth has been on the rise (as that measures the inflation we have been talking about)!
Do you guys think that this way of measuring inflation is consistent – tell me what you think 😉