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The Big Deflation Monster
Chained CPI — Much Ado About Nothing
Macro runs out of gas on food and energy inflation

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A price index is formed by taking a weighted average of prices of a selected group or basket of goods and/or services. We have already encountered one price index before – the implicit GDP deflator. It is the broadest price index in the economy.

“Mathematical” inflation is defined as the percentage change in a price index. If a price index equaled 150 and then later increased to 165 – you would call that a 10% inflation rate.

There may be several measures of inflation for a given country (or city or state) because there are several price indices.

The CPI is an index of prices of goods and services purchased by consumers. See links below for more information.

The implicit GDP price deflator is the index of the prices of all the goods and services included in GDP. This is called a broader price index because it contains a wider and larger set of goods and services than are included in the CPI.  

The PCE price deflator is an index of all the goods included in the consumption component of GDP. The PCE deflator and the CPI attempt to measure the same kind of inflation. They differ somewhat because the Commerce Department’s definition of consumer goods differs somewhat from the Labor Department’s basket of goods for the CPI.

The Producer Price Index is an index of prices paid by firms for finished goods.

Inflation is measured, therefore, as the rate of change of a price index (e.g. the CPI, the GDP deflator, the PCE deflator, the producer price index).

The following link contains several graphs of inflation from the St. Louis Fed: http://research.stlouisfed.org/publications/net/page8.pdf

These long-run charts, reproduced below, show the long gradual decline of inflation, regardless of which measure of inflation is chosen. The PCE price deflator is not among these charts. There are separate inflation measures on the top chart for GDP and for the domestic purchases part of GDP (does not include prices of goods or services exports). Notice the general downward trend in inflation since 1990.  Consumer price inflation was negative only once – in 2009. Producer prices have shown deflation several times. As of early 2011 US inflation is low – but is rising.

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A rise in the rate of inflation is often called reflation.

Disinflation refers to a time when the rate of change of prices is falling while the inflation rate is positive. For example, when the inflation rate goes to 2% after it was 3%, we would say this is a bout of disinflation.  It is the opposite of reflation ⎯ when the inflation rate rises. Reflation is used sparingly. Notable disinflation periods would include: the 1980s before 1987, 1991/1992, 1997/1998, 2001, 2002.

Deflation refers to an extended period of time period when the index of prices is falling ⎯ the calculated inflation rate is negative. The only U.S. price index to show any deflation in the recent past is the PPI. PPI deflation periods occurred in 1986, 1992, 1994, 1998, 2001, and 2002. The CPI showed low inflation or disinflation is most of those years – but not deflation. This suggests that business prices are not always pushed through fully to consumer prices.

(macro) Inflation is a widespread (over many goods) relatively permanent increase in the rate of change of prices. Economists use this specific definition because they want to differentiate price changes that have durable macroeconomic impacts from price changes that come and go without affecting the whole economy. That is, in a particular time period mathematical inflation might rise from 2% to 4%. When that happens, there will be further analysis to see how much of that increase should be of concern for macro policy makers – how much of that rise is “macro” inflation?

Macro inflation versus relative price change refers to this question of how much of the mathematical inflation is macro inflation. Inflation is considered to be a macroeconomic phenomenon – meaning it is widespread, persistent, and reflective of the prices of most goods and prices changing. Of course, we never have pure macroeconomic inflation since during any time period, some prices rise quickly, others rise slowly, and still others might fall. When the prices of some goods and services are changing at very different rates from others – we say that relative prices are changing. Relative prices are a microeconomic concept that refers to how the price of one good is changing relative to another one.

Decomposing measured inflation is done, therefore, because of this distinction between macro and micro price change. Economists try to decompose a given inflation rate into two components – core inflation (the macro part) and relative price change.

Core inflation (underlying rate) refers to the performance of most of the prices in the index. For example, if oil prices rise by 50% one month but most other goods prices rise by 1%, we would say we are having high relative price change because of oil prices but core inflation is only 1%. If you see price indices that include everything except food and energy, these are attempts to measure core inflation (because food and energy prices are known to be highly volatile.) The CPI and PPI charts above show you measures of core inflation – CPI or PPI with food and energy prices removed. Notice that through most of 2000 and 2003, the actual CPI line is well above the CPI less food and energy line. That is showing you that core inflation was probably somewhat lower than the actual CPI inflation was showing. Who cares? Both the Fed and all the Fed watchers care. If actual inflation was increasing one would ordinarily expect the Fed to worry about that. But if core inflation (macro inflation) was below actual, then the Fed might be less worried and be less prone to starting policies designed to reduce the inflation rate.

Median inflation is another attempt to measure core inflation. Recall that a median is the data point at the halfway point. If you lined up all the goods in a price index by the size of the rate of change that month and then you took the inflation rate of the item right in the middle of the list, then this would be the median inflation rate for that month.

Neutral inflation refers to the impact of the change in inflation. Neutral means that the inflation only impacts nominal variables like wages and nominal interest rates. It implies that the inflation ⎯ if it is truly neutral ⎯ does not impact the purchasing power of variables like real output, employment, the real wage, real interest rates, etc.  

Hyperinflation is a very high rate of inflation. To be called hyperinflation it usually has to exceed 50%. History has some spectacular examples of hyperinflation. In Germany, inflation exceeded one million percent in 1923. At that time it took about a trillion Marks to buy one dollar. It was said that a wheelbarrow full of money would not buy a newspaper….unless the wheelbarrow came with the money!

Inflation and exchange rates are closely linked. If a county runs a higher inflation rate than its major trading partners then domestic and foreign consumers may divert their purchases away from the country with the higher prices. When they buy less goods and services from that country they also demand less of their currency, causing it to weaken or depreciate. If investors loose confidence in a currency, capital flight might occur and further weaken the currency. This scenario might not be crucial for the U.S. but has recently been observed for several Latin American countries. Of course, investors in the U.S. in 2002 shared this kind of a worry and some still do.

Chris Giles writes in the Financial Times (September 13, 2006, page 4 of the Special Report Global Economy) “Statisticians have a near-impossible task.” His article points to many difficulties in comparing inflation across countries but laments, “Differences on the goods and services chosen, various formulas for calculating price changes, and divergent view on the types of households to be included render international comparisons a hazardous business.” One big difference in various prices indices is how they treat the price of homes. One philosophy is that a home is an asset –- not a good or service – so it shouldn’t be included in a price index. A second philosophy is that houses render service, just as a rental unit. Thus the price of this service should be included. A second issue concerns core inflation. While measures of core inflation are interesting and attempt to get more directly at macroeconomic inflation, they do tend to eliminate important price changes. You can’t have it both ways. Giles recommends ignoring published actual inflation and instead focusing one’s interests on forecasts of future inflation. But many forecasts rely on the analysis or extrapolation of past measured inflation. So one cannot get away from measurement problems using forecasts. Possibly better advice is to admit that inflation has many faces. We should evaluate and interpret all of the ones that are relevant. Inflation is not one single thing!

International  Inflation  Application

The following table shows inflation rates across countries. See the below link for updates. http://research.stlouisfed.org/publications/aiet/page7.pdf

Screen Shot 2016-04-24 at 11.18.27 AMA quick perusal of the table shows that inflation differs considerably across countries. What else do we see in this chart?

  • Turkey and Venezuela stand out because they are the only two among these 33 countries to have double-digit inflation rates.
  • Venezuela’s inflation rate fell to 12.5% in 2001 and then rose to 31.1% by 2003. If you wanted to lend money in Venezuela, what interest rate would you prefer?
  • Turkey’s inflation rate was almost 85%  in 1998 and has been declining ever since and reached 25.3% in 2003. As a lender in Turkey what rate might you prefer? How would it compare to the rate you want in Venezuela?
  • Four countries had inflation rates below 1% in 2003 – Israel, Singapore, Switzerland, and Japan. Japan’s inflation rate was negative in the last five years – from 1999 to 2003. For Israel, low inflation is a new thing – 1998 was the second year of single-digit inflation. Singapore and Switzerland are old hands at the low inflation game.
  • 24 countries had inflation rates of less than 3% in 2003. From this group the Philippines and Chile have found ways to significantly reduce their inflation rates. .
  • 8 countries had deflation in 2009 – revealing a unique and common experience of a global recession. Only two showed deflation in 2010.
  • Mexico, Indonesia, and Israel, Korea, Philippines, South Africa and Turkey all  had inflation rates of about 3% or higher in 2009. 13 countries had inflation at or above 3% in 2010. Venezuela’s was almost 30%.