Inflation vs. The Cost of Living

We are now seeing a disconnect between how the public and policymakers/central banks perceive what each calls “inflation”.  The public at large, encouraged by talk from the hard-money gold crowd, are encouraged to see “inflation” whenever certain key prices go up.  Recently we’ve seen gasoline and food prices go up, and along with these price increases more people are worrying about “inflation”.   In reality, they are worried that the “cost of living” is going up.  Rises in the cost of living is not inflation.

Dennis Lockhart of the Atlanta Federal Reserve Bank gave an excellent explanation of the differences between “inflation” and “a rise in the cost of living” in a recent speech.  It is well worth reading in it’s entireity, particularly for any student of macro. Here’s an excerpt (emphasis is mine) of his key points – he explains each in greater detail:

the term “inflation” is misused in describing rising prices in narrow expenditure categories (for example, food inflation). Nonetheless, recent price news has encroached on the public consciousness with the effect that any price rise of an important consumption item is often taken as signaling inflation.

I think it would be helpful, therefore, to remind ourselves of three basic points about inflation and a central bank’s obligation to deliver price stability. They are

First: The rate of inflation encompasses all prices. It is the practical equivalent of the weakening of the domestic purchasing power of our money.

Second: Inflation is to be distinguished from the cost of living. While central banks, and only central banks, can control the domestic purchasing power of our money, central banks are largely powerless to prevent fluctuations in the cost of living.

Third: The primary economic cost of inflation is that it increases the risk associated with long term planning and decision making.

Let me elaborate on these points….

Lockhart goes on to explain some of the difficulties in monitoring (not really measuring) inflation prospects:

To achieve price stability, policymakers must detect inflation in its early stages before it is firmly established, especially in the psychology of consumers and businesses. This early detection is a challenge because inflation is not easily measured in the short term with any precision. No single price statistic enjoys a sufficient vantage point from which to assess inflation in the short term. With imperfect tools, inflation is more easily monitored than precisely measured.

Almost exactly 100 years ago, the economist Irving Fisher, who laid out many of the foundational ideas about money and inflation, likened measuring inflation or the purchasing power of money to tracking a swarm of bees. The swarm is going in a certain direction, while the bees have their own individual movements within the swarm…

Lockhart summarizes with (again emphasis is mine):

Notwithstanding the energy-driven jump in prices in December, underlying inflation is currently below the level that I would define as price stability. My current projection shows underlying inflation gradually rising over the next few years, putting us back into a range consistent with the 2 percent target by 2013. Key to the realization of this inflation forecast is that inflation expectations of the public remain well anchored. And for this to happen, the public has to have a good appreciation of what the central bank is trying to achieve and have adequate faith that we will achieve it.

In these remarks I have made a distinction between rising prices and a rising cost of living versus inflation. It’s a fair question—is this a distinction without a practical difference? Not at all. The distinction is real and important for all of us to grasp. The distinction ought not to be lost on the general public because to understand the intent of current policy, to form reasonable expectations, and to make sound decisions for the long term, the attention should be mostly on the full picture of inflation and the long-term purchasing power of our money. As a policymaker, I watch prices—that is, the behavior of highly evident and prominent prices we all take note of. I am also interested in movements in the cost of living that the great majority of households experience. But I am focused most intently on broad inflation because I believe long-term stable prices to be fundamental to a healthy and growing economy. For the moment, inflation, properly defined, is tame, in my view. And the rise of individual prices does not signal incipient inflation.

Excellent points.