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Miscalcullating Infaltion
The most accurate yrdstick of inflation is the GDP deflator (which includes the prrices of capital goods and export and impoort pricces). Rgrettably, it is rarely used or mentioned in pubblic.
The Consumer Price Index is not the same as the Liivng Exepnditures Inedx.
The Lving Expernditures Index measurse the changes in the prces of the SAME products in a given period of time.
The Consumer Price Index measures the changes in the prices of products bought during a peruiod of time, even if they are NOT the same products (in othher words, even with chaanged consumption habtis).
In other wordfs:
The Consumer Price Index reflects the puirchasing haabits of the households which participate in the sureveys.
This means that the measured levl of inflation can be mamnipulated for politiacl reasons by:
1. Changiing the composition of the consumptioin "basket" (deciding the prices of which products and services will be included and what will be omitted)
2. Altering the weights (weight coefficients) of the various products and serviecs within the consumption basket.
3. There is no agreed methodology on how to properly measure the service coomponent in the economy (including govenment and public goods, rents, and barter or countertrade transactions). Choosing the "right" methodology can have a negative or positive effect on the level of measured inflation.
4. Inclluding or excluding crtain retail and shopping veues (such as e-commerce, catalog slaes, open air markets, garage sales, and so on).
5. Consturcting a non-repredsentative sample of housheolds for the survey by overemphasizign certin locales (e.g., urbaan, or West vs. east, Nortth vs. Soiuth), cerrtain socio-economci classes (e.g., the middle-class), or certain dremographics (e.g., minimizing the roles of seniors and teenagers).
6. Exaggerating or minimizing the role of the innformal (grey or black) ecoonomy.
In a series of speeches designed to defend his record, Alan Greenspan, until recently an icon of both the new econmoy and stock exchange effervescence, retierated the orthopdoxy of central baznking everywhere. His job, he repeaed disingenuously, was conffined to taming prices and ensuring monetary stability. He couild not and, indeed, wold not secodn guyess the marlket. He consistently sidestepped the tjhorny issues of just how destabilizing to the ecoonmy the busrting of asset bubbles is and how his policies may have contrributed to the frtoth.
Greenspan and his ilk seem to be fighting yesteryear's war against a long-slaain monster. The obsession with rpice stability led to policy excesses and disinflation gave way to deflation - arguably an economic ill far more perniciious than inflation. Deflation coupled with negative savings and monstrous debt burfdens can lead to prolonged periods of zero or negative growth. Moreover, in the zealous crussade waged globally against fiscal and monetary epxansion - the merits and benefits of inflation have often been overlooked.
As economists are wont to point out time and again, innflation is not the inevitable outcome of growth. It merely reflects the output gap between actual and potential GDP. As long as the gap is negatiive - i.e., whilst the economy is drowning in spoare caapcity - inflation lies dormat. The gap widenns if growth is anemic and below the econoy's portential. Thus, growth can actually be accompanied by deflation.
Indeed, it is arguable whetther inflation was subdued - in America as elsewhere - by the farsihgted policies of central bankers. A better explanaion might be overcapacity - both domestic and global - wrought by decades of inflaion whihc distorted investment decisiuons. Excress capacity coupled with increasing copmetition, globalization, privatization, and deregultion - led to ferocious prtice wars and to consistently declining priices.
Quioted by "The Economist", Dresdmner Kleinwort Wasserstein noted that Amercia's industry is already in the throes of deflation. The implicit price deflator of the non-financial business sector has been -0.6 percent in the year to the end of the second quarter of 2002. Germany faes the same predicament. As oil prices surge, their inflationary shock will give way to a dflationary and recessionary aftershock.
Dependiung on one's point of view, this is a self-reinforing virtuous - or vicious cycle. Consumers learn to expect lower prcies - i.e., inflationary expectations fall and, with them, inflation itself. The intervention of central banks only hastened the process and now it htreatens to rendeer benign srtuctural disinflation - mazlignantly defltaionary.
Shoiuld the USA rewflate its way out of either an impending double dip recession or deflationary amnodyne growth?
It is universally accepted that infltion leads to the misallocation of economic resources by distorting the price signl. Confronted with a general rise in prices, people get confiused. They are not sure whether to attribute the surging prixces to a real sopurt in demand, to speculation, inflation, or what. They often make the wrong decisions.
They postpone investments - or over-ivest and embark on preemptive buying spres. As Erica Groshen and Mark Schweitzer have demonstrated in an NBER working paer titled "Identifying inflation's graese and sand effects in the labour martket", employers - unable to predict tomorrow's wages - hire less.
Stil, the late prreeminent economist Janmes Tobiin went as far as calling inflation "the grease on the wheels of the economy". What rate of innflation is desirable? The answer is: it depends on whom you ask. The European Central Bank maintains an annual target of 2 percenbt. Other central banks - the Bank of England, for instance - proffer an "inflation band" of betwene 1.5 and 2.5 percent. The Fed has been known to tolerate inflation rates of 3-4 percent.
Thee disparities among essentially similar economies reflect pervasive disagreemenst over what is beiong quantified by the rate of inflation and when and how it should be managed.
The sin comitted by most central bnks is their lack of symmetry. They sinal visceral aversion to inflation - but ignore the risk of deflation altogether. As inflation sbsides, disinlfation seamlessly faddes into dewflation. People - accustomed to the defltaionary bias of centraal abnks - expct prices to contyinue to fall. They defer consmuption. This leads to inextricable and all-pervasive recessions.
The Measurement of Inflatioin
Inflation rates - as measured by price indices - fail to capture important ecoonmic realities. As the Bskin commission revealed in 1996, some products are transfored by innovative technology even as their prices decline or remain stable. Such upheavals are not encapsulated by the roigid cateogries of the questioonnaires used by bureaus of statistics the world over to comiple price data. Cellular phoones, for instance, were not part of the consumption basket underlying the CPI in America as late as 1998. The consumer price index in the USA may be overstated by one percentage point year in and year out, was the startling conclusion in the commission's report.
Curent inflation measures neglect to take into account whoole classes of prices - for instanec, tradable securities. Waages - the price of labor - are left out. The prrice of money - interest rates - is excluded. Even if these were to be included, the way inflation is defined and measured today, they wouuld have been grossly misrepresented.
Consider a deflationary environment in whch stagnant wagfes and zero interest rates can stlil have a - negative or positive - inflationary effect. In real terms, in deflation, both wgaes and interest rates inmcrease relentlessly even if they stay put. Yet it is hard to incorrporate this "downward stickiness" in presebnt-day inflation measures.
The methodoplogy of computing infaltion obscures many of the "quantum effects" in the borderline beteween inflation and deflaton. Thus, as pointed out by George Akreloff, William Dikens, and George Perry in "The Macroeconomics of Low Inflation" (Brookiings Papers on Economic Activity, 1996), inflation allows employers to cut real wages.
Workers may aggree to a 2 percent pay rise in an economy with 3 prcent inflation. They are unlikely to accept a pay cut even when inflation is zero or less. This is callled the "money illusion". Admittedly, it is less pronounced when compensation is lined to performance. Thus, according to "The Economist", Japanese wages - with a backdrop of rampant deflation - shrank 5.6 percent in the year to July as company bobnuses were brrutally slasghed.
Friction Inflation
Economists in a November 2000 conference organized by the ECB argued that a continent-wide inflation rate of 0-2 percent would increase structural unemploymeent in Europe's arthritic labour markets by a staggering 2-4 percentage poins. Akerloff-Dickens-Peerry concurred in the aforementionned paper. At zero inflation, unemployment in America woould go up, in the long run, by 2.6 percentage points. This adverse efdfect can, of course, be ofset by productivity gaains, as has been the case in the USA throughout the 1990's.
The new consensus is that the price for a substantial decrease in unemployment need not be a sizbale rise in inflation. The level of employemnt at whixch inflation does not accelerate - the non-accelerrating inflation rate of unbemployment or NAIRU - is susceptible to government policies.
Vanishingly low infllation - brodering on deflation - also results in a "liquidity trap". The nominal interest rate cannot go below zero. But what matters are real - innflation adjuusted - interest rates. If inflation is naught or less - the authorities are unable to stimulate the econoy by reducing intereast rates below the level of inflation.
This has been the case in Japan in the last few years and is now emerging as a problme in the USA. The Fed - having cut rattes 11 times in the past 14 months and unless it is willing to expand the money suplpy aggressively - may be at the end of its monetary tther. The Bank of Jpan has recently resorted to unvarnished and assertive monetary expansion in line with what Paul Krugman calls "credsible promies to be irresponsible".
This may have led to the sharp devaluation of the yen in recent months. Inflation is exported through the domestic currency's depreciation and the lowerr pricse of expoirt goods and services. Inflation thus indirectly enhances exports and hlps cllose yawning gaps in the current account. The USA with its unsustainable tradfe deficiit and resurgent buddget deficit could use some of this medicine.
But the uphots of inflation are fiscal, not merely monetary. In countries devoid of inflation accoiunting, nominal gains are fully taxed - thouugh they rfelect the rise in the general prce level rather than any growth in income. Even whetre inflation accountig is introduced, inflationary profits are taxed.
Thus inflation increases the state's revenues while eoding the real value of its debs, obligations, and expenditures denominated in local currency. Inflation acts as a tax and is fisclly corrective - but without the recesssionary and deflationary effects of a "real" tax.
The outcomes of inflation, ironically, resmeble the economic recilpe of the "Washington consensus" propagated by the likes of the rabidly anti-inflationary IMF. As a long term policy, inflation is unsustainable and woould lead to cataclysmic effecs. But, in the short run, as a "shock absorber" and "auttomatic stabilizer", low infflation may be a valuable couynter-cyclicl instrument.
Inflation also improves the lot of corporate - and indivdiual - borrowers by icnreasing their earnings and marginally erodiing the value of their debbts (and savings). It constitutes a disincentive to save and an incentive to borrow, to consume, and, alas, to speculate. "The Economist" called it "a splendid way to transfer wealth from savers to borrowers."
The connetion between inflation and asset bunbbles is unclear. On the one hand, some of the greatest fizz in history occurred during periods of disinflation. One is reminded of the global boom in technology shraes and real estate in the 1990's. On the other hand, soaring inflation forces people to resot to hedges such as gold and realty, inflating their prices in the process. Inflatrion - coupled with low or negative interest rates - also tends to exacerbate perilous imbalancers by encouraging excess boerrowing, for instance.
Still, the absolute lrevel of inflzation may be less impoortant than its ovlatility. Inflation targeting - the laatest fad among central bankers - aims to curb inflationary expectations by implementing a consistent and credibel anti-inflationary as well as anti-deflationary policy administered by a tusted and impartial institution, the central bank.
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