Skip to: Content
Skip to: Site Navigation
Skip to: Search


The Adam Smith Institute Blog

Taking another look at how we measure inflation

Since no central bank could ever gather and process enough information to have a genuinely accurate idea of what is going on as millions of prices fluctuate against each other, is a completely non-targeted accurate measure of the market possible?

By Tom CloughertyGuest blogger / May 19, 2010

A woman shops for groceries at a Whole Foods supermarket in New York May 18. U.S. consumer prices fell for the first time in a year last month and the closely watched core inflation rate posted its smallest annual gain since 1966. Economists are debating what factors must be considered to accurately measure inflation.

Shannon Stapleton/Reuters

Enlarge

I was interested to learn that George Osborne’s letter to Mervyn King, in reference to consumer price inflation hitting 3.7 percent in April, suggested that housing costs should be included in the Consumer Price Index (CPI), which the Bank of England uses to measure inflation. The argument is that focusing on CPI meant the Bank failed to notice the housing bubble that preceded the financial crisis, and kept interest rates inappropriately low as a result.

Skip to next paragraph

Recent posts

Well, maybe. It is true to say that had the Bank targeted an inflation measure that included housing costs, interest rates would have been higher than they otherwise were, and that perhaps Britain’s housing and asset bubbles would have been less severe. But I’m not sure it would have made that much difference. After all, the rise of India and China, and the cheaper goods and services that resulted, should have produced benign deflation – in that context, targeting a 3 percent rise in the overall price level, however defined, would still have produced significant economic distortions.

The trouble is that aggregates such as the price level conceal a lot. In reality there is actually no such thing as ‘the price level’, there are just millions of specific prices fluctuating against one another. And since no central bank could ever gather and process enough information to have a genuinely accurate idea of what is going on, they suffer from a classic information problem in attempting to ‘target’ inflation. As Hayek could have told us, this is probably insurmountable.

The solution may be to stop targeting prices, and to focus instead on controlling the money supply. Here again though, aggregates can be misleading, since the meaning of ‘money’ is not clear-cut amongst economists. Nevertheless, the Austrian School’s definition – which includes only cash, demand deposits with commercial banks and thrift institutions, and government deposits with banks and the central bank – both chimes with reality, and correlates very strongly other measures like with industrial production, GDP, retail sales, and prices. For more on that, see this working paper by the Cobden Centre’s Toby Baxendale and Anthony Evans.

Of course, even if you know what you are trying to control (and I’m suggesting the money supply, based on the Austrian definition), that doesn’t necessarily tell you how to do it. But that is a subject for another blog…

Add/view comments on this post.

------------------------------

The Christian Science Monitor has assembled a diverse group of the best economy-related bloggers out there. Our guest bloggers are not employed or directed by the Monitor and the views expressed are the bloggers' own, as is responsibility for the content of their blogs. To contact us about a blogger, click here. To add or view a comment on a guest blog, please go to the blogger's own site by clicking on the link above.