The trouble with inflation indices

By: Wolfgang Münchau

The first time I ever began to doubt my country’s cost of living index was in 2002 when euro banknotes and coins were introduced. In Germany, where I was living at the time, the prices charged by many hotels, restaurants and dry cleaners effectively doubled. If you spent a lot of time travelling, as I did at the time, the personal inflation shock was severe. I estimated my personal inflation rate in 2002 to be approximately 10 per cent. The central bankers were in denial because the official inflation index did not register any significant movements. It must have been in people’s heads. But this was nonsense. The problem was that the official inflation index no longer reflected many people’s personal shopping basket. The index basket is full of manufactured goods largely produced in Asia, while we spend most of our money on services, such as childcare, education, healthcare, transportation, travel and gastronomy.

Luckily for us, this seemed to have been a one-off effect. But the problem of a persistent gap between a central bank’s target price index and a separate measure used by the public has recently become more acute in the UK and the US. The Bank of England targets the so-called consumer price index, while most people in the UK sensibly rely on the old retail price index, which gives a far truer picture of the cost of living including housing. Both indices have registered increases recently. But whereas the CPI has most recently grown at an annual rate of 3.1 per cent, the RPI has gone up by close to 5 per cent. The gap between the two is large and persistent. When that happens, a central bank has a problem. On a recent visit to South Korea, I was told that the same was happening there: prices were rising everywhere, yet the price index gives the illusion of price stability.

Potter Stewart, a former US Supreme Court justice, once famously remarked that he could not define hardcore pornography, but he knew it when he saw it. You could say the same for inflation. There is no single indicator that fully captures price stability. Yet everybody feels inflation when it occurs.

The answer is not to switch to another index, but to admit that the notion of price stability requires a broader definition. Various indices, house price inflation and the cost of rents and mortgages should all form part of a judgment about price stability. So should the rate of monetary expansion and credit growth. If you judge UK inflation on a broader scale, you would undoubtedly come to the conclusion that the UK has an inflation problem.

My problem with UK monetary policy is therefore not that the Bank of England has overshot its target range. It is perfectly normal for central bankers to make mistakes from time to time, and the Bank of England has had a good record to date. My problem is that they have a too narrow view of price stability. The latter is inextricably linked with its strategy of direct inflation targeting, the most common monetary strategy in the world nowadays, which commits a central bank to chase after a single number.

The Federal Reserve follows a reasonably well-behaved core inflation index, yet this index has become totally irrelevant for middle-class families* who spend most of their income on items such as education and healthcare, where cost inflation has exploded. While the official indicators are extremely convenient for policymakers, nobody in their right mind would rely on a measure that persistently misjudges what 21st century families spend their money on.

I would argue that despite my experience in 2002, the eurozone is relatively better off compared with the UK and the US. That may not be true of every country in the eurozone, for example Spain. But just as monetary union transforms current account risks into credit risks, it transforms an inflation problem into a competitiveness problem. For the eurozone as a whole, the ECB has done a reasonable job to contain inflation expectations. This is not because the ECB uses a better index – it most certainly does not – but because it takes a broader view of price stability.

A central bank’s job is to contain inflation expectations, which are even more difficult to measure than inflation itself. The current measures of inflationary expectation, for example, market-based measures, are just as error-prone if not more than the measures of inflation. When workers in the UK start to negotiate wages on the assumption that inflation is 5 per cent in an economy close to full employment, as they do now, trouble lies ahead. When it comes to measuring inflation, I would not trust any of the official indices, but resort to Justice Stewart’s test: knowing it when we see it. I would contend that we do.

* The New Economics of the Middle Class: Why Making Ends Meet Has Gotten Harder, Elizabeth Warren, Harvard Law School, Testimony Before Senate Finance Committee May 10, 2007

© The Financial Times Limited 2007

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