Primer: Inflation Versus Rising Prices

One source of complexity in economic discussion is the ambiguity of the term "inflation." The usual definition is that this is the rate of growth of a price index of consumer goods (such as the CPI). However, economists quite often distinguish sustained rises in the price index versus one-time shocks. Unfortunately, it is difficult to determine whether a rise in prices is going to be sustained. For this reason, it is useful to avoid discussing generic inflation, and use more precise terminology.

Consumer Price Indices Versus Other Prices

One of the first questions we face: why use a consumer price index when talking about inflation? There is no reason why we must use this convention, but it does make sense for many people, including the bulk of my readership.

• Central bankers are typically charged with attempting to keep the inflation rate near a certain target -- inflation targeting. This is typically the consumer price index, but the Federal Reserve prefers to target the core (ex-food and energy) Personal Consumption Expenditure deflator. Therefore, anyone interested in monetary policy will use this measure as the measure of "inflation."
• Inflation-linked debt are usually indexed to the domestic Consumer Price Index. This means that "inflation" for bond market participants refers to this measure.
• Indexation (for pensions, for example) is typically based on the Consumer Price Index.
• The Consumer Price Index is typically the closest measure to capture the "cost of living," and so is followed in the media.

One could look at the widest measure of prices in the economy -- the GDP deflator, and it is used sometimes. However, the GDP deflator is designed for GDP calculations, and has some unusual properties when used as a price index. The best known problem is how import prices are treated. Since imports subtract from GDP, a rise in the import price index lowers the GDP deflator. This means that a spike in imported oil prices can cause short-term deflation -- not the most intuitive outcome.

Otherwise, one can move towards narrower price measures. The problem with this is the risk of cherry picking: since relative prices are always shifting, one can always find something that is moving in the direction that fits your story. For example, rising gold prices are often hailed as a sign of inflation, while falling gold prices are the result of various conspiracies.

One-Time Shocks Versus Sustained Inflation

The chart above shows what is usually thought of as 2% inflation -- the price level is rising by 2% per year (the time axis represents months), and the 12-month change is a constant 2%.

Meanwhile the chart above shows another possibility: a one-time price level shock. The price level was fixed at 100 for t<0, and then jumps to 102 (and stays there) at t=0. The annual inflation rate jumps to 2% at t=0, and then falls back to 0% at t=12.

It is easy to distinguish these cases when we have access to the full time history. However, at t=0, an observer cannot be sure whether the change in the inflation rate is permanent or not.

For those with an interest in monetary policy, this distinction is extremely important. Very few people (outside of academia) believe that the central bank can determine the price level on a month-to-month basis, and so no one expects that the central bank could offset a one-time shock. Instead, it has to accept the one-time shock, and try to keep expectations about the future path of inflation under control.

For those who are interested in creating inflation forecasts for things like inflation-linked debt, the distinction between these cases is less important. The payoff is based on the level of the CPI, and so one-time shocks (such as a spike in oil prices) matter. However, one needs to be careful about extrapolating such shocks when looking at long-term breakeven inflation.

Real World Experience

Distinguishing between one-off effects and persistent effects can be attempted when we look in detail at the underlying data. A common example is the effect of an increase in a sales or consumption tax.

The U.K. provided a very good relatively recent example. The poorly-thought out austerity drive by the U.K. government included a value-added tax (VAT) hike. The CPI index was greatly effected, and hit 5% in 2011. However, the "CPI-Y" measure (which excludes indirect taxes) was stuck at a level close to the 2% target (although it was still elevated as a result of sterling weakness). Once the base effect dropped out, the overall CPI inflation rate converged downward towards the rate of CPI-Y inflation.

This is a case where it is fairly safe to ignore the transitory effects on the price level. A VAT hike is a tightening of fiscal policy; only continental European central bankers would think it makes sense to hike interest rates in response to a tightening of fiscal policy.

Other one-time effects are harder to analyse. A key example are oil price spikes. In recent decades, oil price hikes have essentially represented one-time shocks to the price level. Energy prices are embedded in many goods and services, and so the effect is relatively widespread in consumer price indices. However, once the effect has worked its way through the system, overall inflation rates reverted to their trend level.

Conversely, the effect in the 1970s was quite different. Oil price spikes helped feed the upward march of all prices. Wages incorporated cost-of-living increases, and the indexation helped feed the continued march of inflation. I am going to avoid discussing the 1970s inflation further here, but it is clear that there were a lot of "one time" effects that all pushed prices in the same direction, and it is hard to distinguish them from "persistent" sources of inflation.

In order to have confidence in our ability to predict long-term trends in inflation, we need to have confidence in our ability to explain why the reaction to one-time events in the post-1990 era are different than in the 1970s. (I certainly have views on that topic, but I am not going to commit myself ahead of finishing my research programme for a book on inflation.)

Concluding Remarks

Whether or not price level changes are persistent is a large question, and the answer is a major component of a research programme to explain inflation.

(c) Brian Romanchuk 2017