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.


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.

CPI: Deflation Watch

The September Consumer Price Index numbers are out. Inflation is really a sustained general increase in the level of all prices.  Since the price index itself can be rather noisy, varying a lot from month-to-month, many economists use some different techniques to smooth out the trend to see what the “sustained” action really is.  Three of the most popular ways of smoothing out the noise are called core CPI, median CPI, and trimmed-mean CPI.  In all three cases, the signals they are sending are not encouraging for recovery.  We are not yet into true deflation territory where prices are actually falling instead of increasing, but we are very, very close.  Both deflation and high inflation are undesirable.  But the risks are not symmetric.  Even very small amounts of deflation can be difficult to eliminate and can easily push an economy into a very prolonged period of stagnation or decline.  Inflation, on the other hand, can be more easily brought down if it gets too high.  Further, inflation at low levels, such as 2-4% isn’t very harmful at all.  In fact, a case can be made that 2-3% inflation is much more desirable than no inflation.

I like to think of managing inflation/deflation as driving down a desert road at the edge of cliff.  On the deflation side of the road is steep cliff with no guardrail.  On the inflation side of the road is a desert strewn with rocks.  Messing up and getting into inflation will get rocky and messy, but it’s manageable and survivable.  Erring on the side of deflation and things get real bad, real fast.   Best to leave a little margin of 2-3% inflation to make sure there’s no accidental plunge into real deflation.  For more than a year now, we’ve been playing daredevil with our economic futures by getting way too close to deflation.

Calculated Risk explains and offers one of their as-usual outstanding graphs:

…these three measures: core CPI, median CPI and trimmed-mean CPI, were all below 1% in September, and also under 1% for the last 12 months.

Inflation MeasuresClick on graph for larger image in new window.

This graph shows these three measure of inflation on a year-over-year basis.

They all show that inflation has been falling, and that measured inflation is up less than 1% year-over-year. Core CPI and median CPI were flat in September, and the 16% trimmed mean CPI was up 0.1%.

One last note about these numbers.  When The Fed increased it’s balance sheet dramatically two years ago to help bail out the banks and stabilize the financial system, the Austrians, Monetarists, gold bug types, and general austerians all complained that The Fed was leading us into a hyperinflation.  When the federal government budget blossomed into multi-trillion dollar deficit in early 2009, the same people warned us that it would lead to hyperinflation.  Now, 20-24 months later, we can conclude they were wrong. Their models are wrong and therefore the policy advice is wrong.  Deficits do not lead to hyperinflation when you have double-digit unemployment. Period.

Hamilton Explains Why Deflation Is Bad

James Hamilton at Econbrowser explains why deflation is bad:.

It is also quite clear to me that deflation– an increase in the number of goods you can buy with an individual dollar– can be even more destructive. Since this may be less obvious to many readers, let me review some of the reasons why I say that.

For people struggling under debt burdens, deflation makes repaying the loan more difficult and less likely to happen. If that leads to a wave of bankruptcies, everyone, including creditors, can end up losing out. Debt burdens and delinquencies remain a significant problem holding back the economic recovery today. These problems would magnify enormously if a serious deflation were to get underway.

Deflation also means you can earn a positive rate of return just by stuffing money in your mattress. That creates an incentive for consumers, firms and banks simply to hoard cash rather than invest it productively. Even very sound investments can have a hard time competing for lenders’ dollars when the alternative of hoarding becomes sufficiently lucrative.

I’m personally persuaded that the 25% drop in the overall price level in the U.S. between 1929 and 1933 was one factor contributing to the depth and severity of the Great Depression. Our recovery began pretty dramatically when the U.S. reflated by dropping parity of the dollar with gold in 1933. Other countries had a similar experience– things began to improve only after prices began rising.

Today the U.S. is flirting with deflation, as we have been for well over a year.  We are flirting with much more serious trouble than what we have already seen.


Smells Like Deflation

Oh, buried in the press release on 2nd Qtr 2010 GDP estimates is this item:

The price index for gross domestic purchases, which measures prices paid by U.S. residents,
increased 0.1 percent in the second quarter, the same increase as in the advance estimate; this index
increased 2.1 percent in the first quarter.  Excluding food and energy prices, the price index for gross
domestic purchases increased 0.8 percent in the second quarter, compared with an increase of 1.6
percent in the first.

Gee, 0.1%! That’s pretty close to zero and the negative numbers. Deflation (negative inflation on the price index) isn’t going to help us. In fact, it’s likely to make things much worse.

Why is deflation so bad?  After all, when we’re shopping we always look for ‘lower prices’, so why is deflation, which is a general decline in prices so bad?  The answer is the difference between micro and macro and the fallacy of composition.   When it’s just the price of one item and we are the buyer, then lower is good – it’s a better value.  But remember there’s a person that wants that price to be higher – the seller.  And in macro, when we’re talking about the entire economy, we are all not only buyers, but all of us are also sellers.  So the logic from micro that lower prices are good only holds true for consumers/buyers of particular goods.

There are two reasons why deflation, a general drop in most prices, is bad.  First, it discourages people from spending. If a purchase is at all delay-able, then it makes sense to wait because the price may be lower.  But that also means less spending in general and less employment as firms can’t sell their existing inventory.  This particularly applies to consumer durable goods industries (cars, appliances, computers), but it also heavily hits business investment spending and housing investment.

The second reason, and more severe, is because deflation means incomes/wages are not going up either. In fact, deflation means incomes are dropping. But your payments and debts on earlier purchases don’t decline.  So payments on debt take an increasing share of our incomes leaving less and less to spend on GDP.

Yeah, it smells like deflation. And that’s not a good smell.

CPI and Velocity of Money data for January indicate deflation worry

From Angry Bear:

Beginning of the year economic blues in the US? I think so. Just looking over Spencer’s CPI post; here is an excerpt (the first paragraph):

The CPI report was encouraging. The total CPI rose 0.2% and the year over year increase is only 2.6%. Although real average hourly earnings fell, real weekly earnings were unchanged.

The core CPI actually fell for the first time since 1982, bring the year over year change in the core CPI to 1.6%. The 6 month SAAR for the core CPI is 0.8%. Despite all the worries about inflation the normal pattern is for the best cyclical reading on the core CPI to occur in the first year or two after a recession. If the economy follows the normal pattern, the core CPI should continue to moderate for another year or two.

My first thought is that I don’t think that this is encouraging at all; and I’m not alone. Core prices fell; these prices are typically very, very sticky. For example, shelter prices are biased upwards in their calculations, but have been declining or unchanged for every month since August 2009. I know that the output gap is not directly observed, except by proxy in the capacity utilization numbers or the unemployment rate; but it must be huge to do this to housing costs.

Look at it differently: the velocity of money improved in October and November of 2009…

… but then took a step back in December of 2009. If this trend continues, non-energy prices are sure to back down much further. There’s just no support for price action at this time – the Fed can’t pull back… it probably should be putting more in.