Yes, Inflation/Deflation is Hard to Measure

One of the hardest concepts for Principles students, politicians and pundits, oh heck, just about everyone to fully grasp is inflation.  A big part of the reason is because inflation is an abstract concept that is not directly measurable.  We can conceive of it, but we can’t measure it.  I’m no physicist (and open to correction) but it strikes me that it’s a bit on par with “momentum” or “latent energy” in physics.   We don’t have direct-measuring energy-o-meters.  We measure the effects and infer the energy.  Inflation is similar.  We can conceive of a generalized, across-the-economy, sustained trend pushing all/most prices upward such that the unit of money is losing real value in general terms.  Inflation is the sustained push behind all prices. We can’t measure that directly. But we can measure the effect it has: rising prices. The problem comes in that not all prices will be rising at the same time or by the same amount.  Further, during any time period, at least part of the change in price for any good is it’s change in real price relative to all other goods (supply and demand as taught in micro).

We try to deal with this measurement issue by creating a price index – an index that tracks the changes in shopping list of goods over time.  But any price index is a just a subset of all the prices.  Even the Billion Price Project index at MIT admittedly misses most services and lots of consumer goods that aren’t available online.  Price indices are very imperfect beasts.  They have many faults, not the least of them being that they often tend to be volatile in nature.  Since we’re looking for an estimate of inflation which means sustained increases, we need to massage the data further by creating some kind of “core inflation” measure or “trimmed means” type price index.  I’ll explain those some other time.

What prompted today’s post is an article in Bloomberg and a post by Krugman about it.  Together they illustrate one of the reasons so many people want to believe we have greater inflation than we really do.  Companies like to disguise price changes.  They don’t want to be known that prices could be cut in response to demand. Example: auto company offers $2000 rebate on $20,000 car but won’t cut price by 10%, or a firm offers a “value meal”, or they offer a freebie bundled product.  Similarly they often disguise price increases by reducing sizes or portions or by changing the financing.  From Krugman:

Good article in Bloomberg:

Procter & Gamble Co.’s failure to raise the price of Cascade dishwashing soap shows why investors are buying Treasuries at the lowest yields in history, giving the Federal Reserve more scope to boost the economy.

The world’s largest consumer-products company rolled back prices after an 8 percent increase lost the firm 7 percentage points of market share. Kimberly-Clark Corp. (KMB) started offering coupons on Huggies after resistance to the diapers’ cost. Darden Restaurants Inc. (DRI) raised prices at less than the inflation rate as patrons order more of Olive Garden’s discounted stuffed rigatoni than it anticipated.

This is basic economics; prices tend to fall, or at least slow their rise, when there is vast excess capacity and weak demand.

As both the article and Krugman’s excerpt show, we’re closer to deflation than most people realize.  They don’t see the failed attempts to raise prices.  They don’t see the shifts in portions or increase in coupons that reduce effective prices.  What they do see and remember is the $.50 increase in a loaf of bread or the $.70 increase in a gallon of gas.  But even with the gas, they selectively remember the $.70 price increase in summer, but forget the $.75 price drop in autumn.  Inflation and deflation are tricky things to measure.


Once Again, No Inflation Round Here

Once upon a time, increasing inflation was a problem for the U.S.  But that time was a generation ago – 1966-1980 to be precise, over 30 years ago.  Since then it’s down, down, down. We’re now bumping along at near zero inflation and we’re flirting with deflation.  Yet, many of the talking-heads class continue to fear and rave on-and-on about inflation.  Republicans this week grilled Ben Bernanke in Congressional hearings, urging him to fight harder against inflation (see here for a good sarcastic analysis).  So I’m going to let David Leonhardt of the New York Times do the writing here:

On Capitol Hill, members of Congress are grilling Ben Bernanke, the Federal Reserve chairman, about his attempts to lift economic growth by reducing long-term interest rates — the Fed’s so-called Q.E.2 program, or quantitative easing. Some members of Congress think Mr. Bernanke is fighting the wrong battle. They want him to take steps to stamp out inflation, which they believe is dangerously high or soon will be.

Here is core inflation — economists’ preferred measure of inflation, because it’s more predictive than headline inflation — over the last 40 years:

Does it look dangerously high?

Or might the slow pace of economic growth and the high level of unemployment be larger problems?

Now just in case you’re thinking, “yeah he’s just a journalist and that’s only the Core CPI measure”, let’s see what the other measures are saying.  I turn to a graph Menzie Chinn of Econbrowser:

First, inflation rates for core CPI, personal consumption expenditure deflator, and PPI (finished goods), on a three month annualized basis, are either under 1 percent, or in the case of the PPI, less than zero percent.

Figure 1: Three month annualized inflation for core CPI (blue), core personal consumption expenditure deflator (red), and core PPI (green). NBER recession dates shaded gray. Source: BLS, BEA via FREDII, and author’s calculations.Second, what about pressures from the labor market? Labor compensation (so, wages and salaries and benefits) is growing at 2 percent (q/q, annualized).

Figure 2: Quarter-on-quarter annualized growth rates for private sector labor compensation (dark blue) and unit labor costs for nonfarm business sector (orange). NBER recession dates shaded gray. Source: BLS, BEA via FREDII, and author’s calculations. However, the relevant cost of labor to a firm is the compensation cost divided by per hour output, i.e., unit labor costs. In 2010Q4, the q/q annualized growth rate of this series was a negative figure.

Of course, if you’re wealthy and heavily into financial assets (like say Bill Gross of PIMCO), then you want to continue to fight inflation and get that rate even lower, maybe even into deflation.  After all owners of financial assets get wealthier in real terms when deflation happens. Of course deflation will destroy the economy and anybody who owes money, but they don’t seem to care about that.