Miscalculating,Inflation,The,m finance, share, loan Miscalculating Inflation

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The most accurate yardstick of inflation is the GDP deflator (which includes the prices of capital goods and export and import prices). Regrettably, it is rarely used or mentioned in public. The Consumer Price Index is not the same as the Living Expenditures Index. The Living Expenditures Index measures the changes in the prices 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 period of time, even if they are NOT the same products (in other words, even with changed consumption habits). In other words: The Consumer Price Index reflects the purchasing habits of the households which participate in the surveys. This means that the measured level of inflation can be manipulated for political reasons by: 1. Changing the composition of the consumption "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 services within the consumption basket. 3. There is no agreed methodology on how to properly measure the service component in the economy (including government 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. Including or excluding certain retail and shopping venues (such as e-commerce, catalog sales, open air markets, garage sales, and so on). 5. Constructing a non-representative sample of households for the survey by overemphasizing certain locales (e.g., urban, or West vs. east, North vs. South), certain socio-economic classes (e.g., the middle-class), or certain demographics (e.g., minimizing the roles of seniors and teenagers). 6. Exaggerating or minimizing the role of the informal (grey or black) economy. In a series of speeches designed to defend his record, Alan Greenspan, until recently an icon of both the new economy and stock exchange effervescence, reiterated the orthodoxy of central banking everywhere. His job, he repeated disingenuously, was confined to taming prices and ensuring monetary stability. He could not and, indeed, would not second guess the market. He consistently sidestepped the thorny issues of just how destabilizing to the economy the bursting of asset bubbles is and how his policies may have contributed to the froth. Greenspan and his ilk seem to be fighting yesteryear's war against a long-slain monster. The obsession with price stability led to policy excesses and disinflation gave way to deflation - arguably an economic ill far more pernicious than inflation. Deflation coupled with negative savings and monstrous debt burdens can lead to prolonged periods of zero or negative growth. Moreover, in the zealous crusade waged globally against fiscal and monetary expansion - the merits and benefits of inflation have often been overlooked. As economists are wont to point out time and again, inflation is not the inevitable outcome of growth. It merely reflects the output gap between actual and potential GDP. As long as the gap is negative - i.e., whilst the economy is drowning in spare capacity - inflation lies dormant. The gap widens if growth is anemic and below the economy's potential. Thus, growth can actually be accompanied by deflation. Indeed, it is arguable whether inflation was subdued - in America as elsewhere - by the farsighted policies of central bankers. A better explanation might be overcapacity - both domestic and global - wrought by decades of inflation which distorted investment decisions. Excess capacity coupled with increasing competition, globalization, privatization, and deregulation - led to ferocious price wars and to consistently declining prices. Quoted by "The Economist", Dresdner Kleinwort Wasserstein noted that America'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 faces the same predicament. As oil prices surge, their inflationary shock will give way to a deflationary and recessionary aftershock. Depending on one's point of view, this is a self-reinforcing virtuous - or vicious cycle. Consumers learn to expect lower prices - i.e., inflationary expectations fall and, with them, inflation itself. The intervention of central banks only hastened the process and now it threatens to render benign structural disinflation - malignantly deflationary. Should the USA reflate its way out of either an impending double dip recession or deflationary anodyne growth? It is universally accepted that inflation leads to the misallocation of economic resources by distorting the price signal. Confronted with a general rise in prices, people get confused. They are not sure whether to attribute the surging prices to a real spurt in demand, to speculation, inflation, or what. They often make the wrong decisions. They postpone investments - or over-invest and embark on preemptive buying sprees. As Erica Groshen and Mark Schweitzer have demonstrated in an NBER working paper titled "Identifying inflation's grease and sand effects in the labour market", employers - unable to predict tomorrow's wages - hire less. Still, the late preeminent economist James Tobin went as far as calling inflation "the grease on the wheels of the economy". What rate of inflation is desirable? The answer is: it depends on whom you ask. The European Central Bank maintains an annual target of 2 percent. Other central banks - the Bank of England, for instance - proffer an "inflation band" of between 1.5 and 2.5 percent. The Fed has been known to tolerate inflation rates of 3-4 percent. These disparities among essentially similar economies reflect pervasive disagreements over what is being quantified by the rate of inflation and when and how it should be managed. The sin committed by most central banks is their lack of symmetry. They signal visceral aversion to inflation - but ignore the risk of deflation altogether. As inflation subsides, disinflation seamlessly fades into deflation. People - accustomed to the deflationary bias of central banks - expect prices to continue to fall. They defer consumption. This leads to inextricable and all-pervasive recessions. The Measurement of Inflation Inflation rates - as measured by price indices - fail to capture important economic realities. As the Boskin commission revealed in 1996, some products are transformed by innovative technology even as their prices decline or remain stable. Such upheavals are not encapsulated by the rigid categories of the questionnaires used by bureaus of statistics the world over to compile price data. Cellular phones, 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. Current inflation measures neglect to take into account whole classes of prices - for instance, tradable securities. Wages - the price of labor - are left out. The price of money - interest rates - is excluded. Even if these were to be included, the way inflation is defined and measured today, they would have been grossly misrepresented. Consider a deflationary environment in which stagnant wages and zero interest rates can still have a - negative or positive - inflationary effect. In real terms, in deflation, both wages and interest rates increase relentlessly even if they stay put. Yet it is hard to incorporate this "downward stickiness" in present-day inflation measures. The methodology of computing inflation obscures many of the "quantum effects" in the borderline between inflation and deflation. Thus, as pointed out by George Akerloff, William Dickens, and George Perry in "The Macroeconomics of Low Inflation" (Brookings Papers on Economic Activity, 1996), inflation allows employers to cut real wages. Workers may agree to a 2 percent pay rise in an economy with 3 percent inflation. They are unlikely to accept a pay cut even when inflation is zero or less. This is called the "money illusion". Admittedly, it is less pronounced when compensation is linked 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 bonuses were brutally slashed. 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 unemployment in Europe's arthritic labour markets by a staggering 2-4 percentage points. Akerloff-Dickens-Perry concurred in the aforementioned paper. At zero inflation, unemployment in America would go up, in the long run, by 2.6 percentage points. This adverse effect can, of course, be offset by productivity gains, 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 sizable rise in inflation. The level of employment at which inflation does not accelerate - the non-accelerating inflation rate of unemployment or NAIRU - is susceptible to government policies. Vanishingly low inflation - bordering on deflation - also results in a "liquidity trap". The nominal interest rate cannot go below zero. But what matters are real - inflation adjusted - interest rates. If inflation is naught or less - the authorities are unable to stimulate the economy by reducing interest rates below the level of inflation. This has been the case in Japan in the last few years and is now emerging as a problem in the USA. The Fed - having cut rates 11 times in the past 14 months and unless it is willing to expand the money supply aggressively - may be at the end of its monetary tether. The Bank of Japan has recently resorted to unvarnished and assertive monetary expansion in line with what Paul Krugman calls "credible promise 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 lower prices of export goods and services. Inflation thus indirectly enhances exports and helps close yawning gaps in the current account. The USA with its unsustainable trade deficit and resurgent budget deficit could use some of this medicine. But the upshots of inflation are fiscal, not merely monetary. In countries devoid of inflation accounting, nominal gains are fully taxed - though they reflect the rise in the general price level rather than any growth in income. Even where inflation accounting is introduced, inflationary profits are taxed. Thus inflation increases the state's revenues while eroding the real value of its debts, obligations, and expenditures denominated in local currency. Inflation acts as a tax and is fiscally corrective - but without the recessionary and deflationary effects of a "real" tax. The outcomes of inflation, ironically, resemble the economic recipe of the "Washington consensus" propagated by the likes of the rabidly anti-inflationary IMF. As a long term policy, inflation is unsustainable and would lead to cataclysmic effects. But, in the short run, as a "shock absorber" and "automatic stabilizer", low inflation may be a valuable counter-cyclical instrument. Inflation also improves the lot of corporate - and individual - borrowers by increasing their earnings and marginally eroding the value of their debts (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 connection between inflation and asset bubbles 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 shares and real estate in the 1990's. On the other hand, soaring inflation forces people to resort to hedges such as gold and realty, inflating their prices in the process. Inflation - coupled with low or negative interest rates - also tends to exacerbate perilous imbalances by encouraging excess borrowing, for instance. Still, the absolute level of inflation may be less important than its volatility. Inflation targeting - the latest fad among central bankers - aims to curb inflationary expectations by implementing a consistent and credible anti-inflationary as well as anti-deflationary policy administered by a trusted and impartial institution, the central bank. Article Tags: Consumer Price Index, Consumer Price, Price Index, Consumption Basket, Central Banks, Interest Rates