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February 08, 2011

Inflation confusion

As opinion about rising food prices and the consequences thereof divides between "the Fed did it" and "the fundamentals did it" camps, I am reminded of the tricky nature of the semantics of any discussion about "inflation."

In case you need convincing of that yourself, take a look at the results of the most recent Pew News IQ Quiz. Of 13 multiple-choice questions on the quiz, the question that received the fewest correct answers was whether the national inflation rate reported by the government (as of November 2010, when the poll was taken) was closer to 1 percent, 5 percent, 10 percent, or 20 percent. Only 14 percent of the 1001 adults surveyed knew that the answer was 1 percent; more people knew David Cameron is the prime minister of the United Kingdom.

That response does not indicate a general lack of knowledge about economic issues. Seventy-seven percent of respondents knew the deficit is larger now than in 1990s, 64 percent know that the United States runs a trade deficit, and 53 percent are aware that the current unemployment rate is closer to 10 percent than 5 percent or 15 percent. What I think the failure to identify the reported inflation rate probably represents is slippage between the definition of inflation that the average person has in mind and the definition that economists and central bankers are so intently focused upon.

That distinction was the topic of a speech given by Atlanta Fed president Dennis Lockhart earlier today, in which he said:

"In the most recent FOMC statement, following the January meeting, the committee acknowledged the rise of commodity prices, but stated that ‘measures of underlying inflation have been trending downward.'

"Yet inflation anxiety is rising. There seems to be a disconnect between what the Fed is saying and what people are experiencing when they fill up their gas tanks or read about rising food prices around the world.… Are the Fed and the public on different planets?

"Certainly not. But I do think in the swirl of official statements and public discourse we may be talking about different things. To my way of thinking, 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."

The key distinction is the one between the ideas of "the purchasing power of money" and "the cost of living." Again, quoting President Lockhart:

"Let's review what inflation is and is not. Inflation affects all prices. Inflation is not the rise of individual prices or the rise of categories of prices.

"I want to contrast inflation to the cost of living. In casual language, we often interpret a rise in the cost of living as inflation. They are not the same thing. Cost-of-living increases are a result of increases in individual prices relative to other prices and especially relative to income. These relative price movements reflect supply and demand conditions and idiosyncratic influences in the various markets for goods and services. If some component of a household's cost-of-living basket goes up in price, the higher cost of living is not ipso facto inflation."

When food prices rise or oil prices rise, people are right to feel in some sense worse off, because they are. And if you are tempted to call that "inflation," I understand. But for policy purposes, the distinction between cost of living increases and inflation as a deterioration in the generalized purchasing power of money is critical. President Lockhart explains:

"In principle, the central bank could respond to the impact of rising costs in particular markets, but only by exerting downward pressure on the dollar price of all goods and services. Monetary policy is a blunt instrument without the capacity to systematically influence prices in targeted markets. Because monetary policy affects the value of the dollar across the board, the targeted item would still be expensive relative to income and relative to everything else.

"…The Fed, like every other central bank, is powerless to prevent fluctuations in the cost of living and increases of individual prices. We do not produce oil. Nor do we grow food. Or provide healthcare. We cannot prevent the next oil shock, or drought, or a strike somewhere—events that cause prices of certain goods to rise and change your cost of living.

"So monetary policy is not about preventing relative price adjustments dictated by market forces. It is about controlling the broad direction and pace of change of all prices across the economy.

"If monetary policy cannot reliably control the cost of living, what is the point? The point is bringing some certainty to planning and long term decision making of individuals and institutions. This is my third basic point. The benefit of price stability—low and stable long-term inflation—is that it reduces the risk associated with longer-term decision-making and avoids the drag on the economy that uncertainty creates."

There are those, of course, who argue that current policy is, in fact, a source of long-term uncertainty. I will save my commentary on that assertion for a follow-up post.


Photo of Dave Altig By Dave Altig
Senior vice president and research director at the Atlanta Fed

February 8, 2011 in Inflation, Monetary Policy | Permalink

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Comments

Question about oil. Oil products underpin our entire economy. Even if you don't buy oil products directly, you will be impacted by increased oil prices via increased transportation costs for the majority of products you do buy and via increased costs for oil-based products, such as plastics.

If increased oil prices feed into the vast majority of other markets, causing a broad-based increase in prices, is that inflation? Or is "inflation" only a monetary phenomenon?

Posted by: Ned Baker | February 08, 2011 at 06:43 PM

Do I dare say the President seems confused about terminology, though generally on target.

The CPI is a "cost of living index" by construction(Boskin, 1996). However Lockhardt is right all that monetary policy can/should do is manage to the average price change, the CPI, or the COL, and not individual components, or relative prices.

Capitalism, unlike centrally planned economies, depends on price signals and changes thereof, to operate. So yes, hopefully relative prices fluctuate (and if dramatic imbalances, like those brought about by the housing crisis, fluctuate dramatically!). We face that situation now. Overall CPI is muted because housing inflation is very muted, while food inflation(a small part if CPI) is robust.

Posted by: Brynjo | February 08, 2011 at 09:37 PM

""I want to contrast inflation to the cost of living. In casual language, we often interpret a rise in the cost of living as inflation. They are not the same thing. Cost-of-living increases are a result of increases in individual prices relative to other prices and especially relative to income. These relative price movements reflect supply and demand conditions and idiosyncratic influences in the various markets for goods and services. If some component of a household's cost-of-living basket goes up in price, the higher cost of living is not ipso facto inflation."

This paragraph is not clear at all. I think I've worked out what he means, which is that increases in the 'cost of living' might actually simply be 'decreases in the standard of living' (ie negative growth), and not simply price inflation (ie a fall in the value of money). Is that right?

Posted by: Matthew | February 09, 2011 at 01:46 AM

to recap, the problem most of the population has with seeing what inflation is is that they spend far too much of their money on food and energy...they should be spending more on entertainment and electronics and new cars...

Posted by: rjs | February 09, 2011 at 04:04 AM

Lockhart says:

"Monetary policy is a blunt instrument without the capacity to systematically influence prices in targeted markets. "

But is there any other principle to current Fed policy other than attempting to stabilize housing prices? If housing prices drop further, the US banking system fails. The Fed has made it very clear that there are asset prices than it cannot allow to fall. Does anyone deny this?

An honest Lockhart would say that he doesn't care how much other prices rise as long as housing doesn't fall any more.

Posted by: tinbox | February 09, 2011 at 11:23 AM

The distinction between "inflation" and "cost of living" is real only in the terminology of economists and central bankers in order to justify a theory about why monetary policy should control economic growth (though the president of the Atlanta Fed acknowledges that monetary policy is a blunt instrument).

The distinction is essentially between volatile prices of commodities and less-volatile prices of manufactured goods. This perspective must assume that any long-term trends in the former will be reflected in the latter. The conclusion is that inflation must be kept in check, if necessary limiting production by limiting credit. Hence, increasing unemployment.

If pursued consistently, it will stringently limit wage growth. In theory, though not in practice, wages will rise only if workers are more productive. This hasn't happened. So the puzzle of increasingly inequality will be given to a separate department to study, as an anomaly to an otherwise sound theory. And policy will continue the same, viewing wage increases as a main cause of "inflation" which, rightly understood, has nothing to do with the fact that paychecks do not keep up with the cost of living.

Posted by: jcb | February 09, 2011 at 03:15 PM

There are many that are linking QE2 with inflation. That is incorrect. Virtually all of the price inflation in commodities can be traced to a few things.
1. Really bad weather. Wiped out wheat, cotton, cocoa, coffee crops world wide

2. Corn linked to oil via ethanol. 40% of corn crop goes to ethanol.

3. Countries are hoarding commodities for fear that their citizens will revolt. Saudi Arabia is a perfect example

4. Many emerging economies are still expanding, and are utilizing commodities to feed a growing middle class, and to build infrastructure.

Want to see commodity prices( at least food and fibre) drop-pray for real good growing seasons world wide.

Posted by: Jeff | February 09, 2011 at 08:17 PM

Interesting article. Even though I do appreciate the distinction between cost of living and inflation, I believe that this difference is extremely academic.

Because of the correlation between the fed expanding the monetary base, the devaluation of the dollar, and the increase in the price of oil, Cost of Living going up, and inflation going up are in real terms the same thing.

Even though there are extreme circumstances that have occurred recently that have brought about an upsurge in commodity prices that are not linked to the monetary base, to exclude the link completely is too general.

Check out my recent article on the upsurge in prices and the devaluation of the dollar.

Here is the address:

www.thecashflowisking.com

Posted by: Hunter Thompson | February 22, 2011 at 05:13 PM

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