macroblog

April 16, 2012

Taking a deeper dive into the definition of inflation

Sometimes our familiarity with a topic gets in the way of our understanding of it. I often think that about inflation. It's widely known that inflation is a condition of rising prices, or what my favorite macroeconomics text defines more precisely in this way: "Inflation is an increase in the overall level of prices in the economy." And while this idea is serviceable for some purposes, it's pretty inadequate if you try to think about how a central bank goes about the business of controlling inflation.

Here's an example. Friday's retail price report for March revealed that prices rose 3.5 percent from February and averaged 3.7 percent (annualized) over the first three months of the year. I think it's pretty clear we have seen an "increase in the overall level of prices in the economy" this year. But how should the Federal Reserve respond to this rise?

I'm not going to offer an answer that question. I'm a policy adviser, not a policy maker. But we need to dig a little deeper into the textbook to get a better understanding of the inflationary process and how a central bank contributes to that process before we offer up an opinion on the matter.

The inadequacy of the textbook definition of inflation is a topic that's been bugging me for a long time. It's silent about the cause of the rise in prices and therefore does not make any distinction about whether the price increase is a corollary of the policies of the central bank or from another source that a central bank can only nominally influence. This distinction is an important one. (For what it's worth, this 1997 article I wrote explains how I think the term "inflation" has come to be synonymous with "price increase." And here's why I think a deeper appreciation of what constitutes "an increase in the overall level of prices" affects how one thinks about the inflationary experience in real time.)

Here's how economist Irving Fisher put it in his 1913 article "The Monetary Side of The Cost of Living Problem":

"If it can be shown, for instance, that today the good things of this world are becoming scarce on the one hand while money and its substitutes are not becoming plentiful it would be reasonable to conclude that the fault lies with goods and not with money. If, on the contrary, it can be shown that money and its substitutes are becoming plentiful and that goods are not becoming scarce, it is reasonable to conclude that the fault lies chiefly on the monetary side."

Are all price increases inflation? Should central banks use their tools to fight against any rise in costs? The answers to these questions have important implications for how we measure inflation in the short run versus the long run, the horizon over which a central bank ought to be held accountable for achieving price stability, and how monetary policies should be calibrated in the face of rising prices.

In that spirit, the Atlanta Fed has developed an animated video that provides additional perspective on the issue of inflation—specifically, what sorts of price increases are part of the inflationary process that is under the control of the central bank, and which are not. This video is the first in a new series that covers economic issues and the work of the Fed. The video is part of the Atlanta Fed's new feature called "The Fed Explained," which includes a range of new and existing content. We hope these videos stimulate conversation on a range of topics important to the Federal Reserve. The format is targeted to the general public as well as to students and teachers, and we hope it provides an engaging supplement to the study of the Federal Reserve.

Let us know.

Mike Bryan Mike Bryan, vice president and senior economist at the Atlanta Fed

April 16, 2012 in Africa, Inflation, Monetary Policy | Permalink

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Inflation should be correctly defined as the rise in relative prices as a result of an increase in the general money supply. I am not sure if there is a good way to measure this definition but it is important to be properly understood.
The reason is because what needs to be defined is the "bad" price increases. If goods are more efficiently produced in a manner that would bring down prices this is "good". But if those prices are not allowed to drop and are offset due to an increase in the general amount of money, this is still considered inflation "bad" because it removes purchasing power from what would normally be there if intervention in the money supply was not induced even though the price has not changed. Similarly to the situation of a supply glut where a good is scarce; the resulting price increase can occur irrespective of monetary increases and is considered "good". This is because it signals the market to produce more of these goods and reduce demand. This should not be entered into the inflation equation. Therefore, inflation should only be measure as the "relative" prices increase due to the change in money supply.

Posted by: Darryl Jones | April 17, 2012 at 09:48 AM

How about Mish Shedlock's definition of inflation and deflation:

--Inflation is a net increase in money supply and credit.

--Deflation is a net decrease in money supply and credit.

I think he tries to argue that inflation itself is a byproduct of increases in the money supply and credit. Not sure Mish is right, but he is thinking somewhat outside the box.

Posted by: farmland investment | April 17, 2012 at 05:14 PM

I agree totally Mike.

In fact I think inflation can also be understood better simply by looking at its impact on behaviour and attitude to money.

During the pre-crisis years money was plentiful. It was easily available because of easy credit conditions and loose monetary policy. As a consequence people lost respect for money. People both borrowed and lent it stupidly. People spent money today that they would ordinarily have deferred spending until later. These conditions are, to me, inflationary regardless of what price indices told us (although we all know that prices of assets not recorded in the various inflation measures rose considerably).

Now what do we have?

Money is scarce. People have regained respect for money. Banks aren't lending it. Households want to save more. Companies aren't investing. People are deferring today's consumption until later. This, to me, is what deflation is, regardless of what the price indices are telling us.

Today's price rises are squeezing disposable income but workers know that the fragility of the economy can not tolerate much upward wage pressure. Can you really have the type of inflation that destroys competitiveness in these conditions?

Posted by: Peter C | April 18, 2012 at 05:23 AM

Inflation is a net increase in money supply and credit.

Posted by: sunglasses hut | April 19, 2012 at 09:20 AM

If the Fed doesn't know what the definition of inflation is or how to measure it, the Fed should not exist. A surgeon who does not know the outcome of removing one organ and adjusting another should not operate. If the definition of inflation has changed from Friedman's definition to the idea of price increases, why is a rising stock market not considered inflation? This article conjours up a view in my head of a medeival sorcerer mixing frog necks in a bubbling pot casting spells and looking for evidence of success.

Posted by: Bob | April 21, 2012 at 07:06 AM

personally i ask myself this all the time, until i finally hit on Ed Dolan's definition of inflation:

If you could choose between shopping on line today at today’s prices, or buying from a mail order catalog of the past at past prices, what items, if any, would you buy from the past?

with the internet, you can find all sorts of examples (like the $150 bike, $30 helmet, and $25 lock in the 1988 sears catalog can be found in *todays* sears online catalog for the same price).

Its nearly impossible to quantify substitution and quality improvements (the laptop i am writing this on sells new for 50% of what i bought it for 3 years ago). oh, and changing baskets of goods as we retire and consume more health care.

But, making it concrete helps understand what we are talking about. some things, like oil and cars have gone up (except that cars are so much more fuel efficient now, has the all-in price really increased?).

and by the way, that bike has not changed in price sine 1988, but wages have (productivity!) so no wonder I bought a much more expensive bike!

in other words, the more deeply you think about it, the more ephemeral it becomes.

http://www.economonitor.com/dolanecon/2012/03/08/finally-proof-real-proof-not-just-data-of-what-inflation-has-done-to-our-economy/

Posted by: dwb | April 24, 2012 at 05:15 PM

The video was helpful, but I felt like a child watching a cartoon. A little humiliating. The content was good though.

Posted by: Anthony T | April 24, 2012 at 10:09 PM

It may be time to tackle or at least examine inflation from different vantage points within the economy. How about 4 different perspectives: those in poverty/low income families, the middle class, the upper class, and industry. I wonder if aggregating prices with the gross assumption that each price impacts all sections of society equally causes distortions in policy makers perception of what is really going on. I must simply ask should/would Central Bank monetary policy change if we found out that from the middle class perspective inflation was 5,6, 7% or more but in aggregate inflationary pressures were only 2.5%? Maybe someone can reading this blog can provide some guidence but intuitively I would think the relative importance of inflationary pressures decline as income increases. If this were true AND aggregation of price data were shown to skew/smooth inflation data thereby masking the impact of inflation on the middle class and below...Central Bank policy would most likely be out of whack for the majority of people. Just wondering...

Posted by: Danny | April 27, 2012 at 10:29 AM

Today's price rises are squeezing disposable income but workers know that the fragility of the economy can not tolerate much upward wage pressure. Can you really have the type of inflation that destroys competitiveness in these conditions?

Posted by: sunglasses hut | April 29, 2012 at 11:44 PM

As a practical matter, in my working life, The Fed has always defined inflation as increasing wages for ordinary idiots. Thus it has never been "inflationary" for bank executives to quadruple and quadruple again their rake, nor has it been counted as "inflation" when the price of oil went through the roof. And when the price of literal roofs (and the homes beneath them) went absolutely bonkers, from 2002--2006? Not inflation.

That was called "a dynamic and prosperous economy."

My wages have been flat, or nearly so, since I began my working life in 1989. My wage was frozen in 2008, reduced in 2009-2010, restored to its 2008 level last year and remains there now. Adjusted to the official CPI I am paid nine percent less today than I was in 2004.

Ergo: no inflation!

Hence: that insipid video from the Atlanta Fed.

Posted by: Edward Ericson Jr. | April 30, 2012 at 02:09 PM

Consumer prices are not overall prices. In this case they reflect the rise in commodities that the Fed itself has engineered with the various QE's. Overall prices would include labor, perhaps housing and assets. Rental rates are included, and their rise is really from the misery in homeownership.

What is clear is the rise in aggregate prices is not caused by a wage-price spiral or anything close to nearing limits on capacity. Ah, but the magis at the fed are ready to raise rates to stall the economy that is already moribund. (Not that raising rates would not be a good idea for other purposes.)

Posted by: Demandside | April 30, 2012 at 11:19 PM

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July 26, 2007

Why Central Bankers Worry About Fiscal Policy

Today I again hand the keys to Mike Bryan -- now a fellow adjunct faculty member in the University of Chicago's Graduate School of Business -- who provides us with a contemporary example of why it behooves central bankers to speak out when a nation's fiscal situtation gets out of whack:

The reports from Zimbabweover the past year and a half are the stuff that makes for good Money and Banking lectures. It seems that inflation in that country, as officially reported, topped 1,300 percent last year and may now exceed 3,700 percent, with some unofficial reports putting the country’s inflation rate even higher.  Let’s put this inflation in perspective.  If the last reported inflation number can be believed (the country’s Central Statistical Office recently stopped reporting the inflation numbers as it reviews its methodology), prices in Zimbabwe are doubling every month. Inflation of this magnitude renders the government-issued money virtually worthless, wrecking trade and financial institutions in the process.   

While the rate of inflation in the African nation isn’t known for certain, there is little doubt it is extraordinarily high.  Also not in doubt is its cause.  All inflations originate from the same phenomenon—too much money chasing too few goods.  In this case the Reserve Bank of Zimbabwe is rapidly printing Zimbabwe dollars in order to “pay” for a large fiscal shortfall. 

In a recent IMF paper on the Zimbabwe situation the author argues that the Reserve Bank of Zimbabwe’s (RBZ) inflation problems stem not from the usual monetary or fiscal laxness that has triggered other “hyperinflations,” but rather “quasi-fiscal” losses incurred by the central bank itself.  Still, the report concludes that these losses, which stem from some combination of credit subsidies, realized and unrealized exchange losses, and losses from open market operations, were nevertheless incurred to support government policies, and the failure to address these losses has interfered with the monetary management, independence, and credibility of the RBZ.

The immediate “solution” to the Zimbabwe inflation has been the imposition of price controls, an approach that has been attempted by governments ancient and modern, including our own.  I can think of no better source on this topic than economist Hugh Rockoff of RutgersZimbabwe’s controls are actually retroactive, in the sense that merchants have been asked to reduce prices to earlier levels.  Predictably, the problem seems to have gotten worse—now there are even fewer goods for the Zimbabwe dollar to chase.  When and where will the Zimbabweinflation end?  I certainly don’t know.  But I’ve got a pretty good idea how it will end, by a sharp curtailment of their currency expansion.  And that’s the Money and Banking lesson.  If a central bank wants to end inflation, either they better start producing goods, or stop producing money. 

And that, I would add, will be a hard row to hoe unless the fiscal house is put in order.

July 26, 2007 in Africa, Deficits, Exchange Rates and the Dollar, Federal Reserve and Monetary Policy, Inflation | Permalink

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