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Defining and Measuring Inflation
The recent sharp increase in inflation across the world has raised investors’ concerns about the outlook for monetary policy. Will inflation fade away in the coming quarters on its own? Or will central banks realise that they have fallen behind the curve and tighten monetary policy to get back on track? To think about these issues, it is useful to take a step back and consider what economists mean by inflation.
The Merriam-Webster dictionary defines it as “a continuing rise in the general price level” and Dictionary.com views it as “a persistent, substantial rise in the general level of prices.”
Two aspects of these definitions are important.
- They refer to the general level of prices. Price increases that are restricted to a limited number of goods and services do not constitute inflation. To assess general inflationary conditions, economists use some broad index, typically a consumer price index (CPI), but sometimes other indices – such as retail price indices, or a consumption or GDP deflator – are used.
- Inflation is an ongoing process of price increases. A one-off increase in some price, however important, that raises the level of the CPI does not constitute inflation although it will lead to a transitory boost to the rate of increase in prices. Such price level shocks can come from a variety of factors, including energy and commodity prices; exchange rate movements; and changes in indirect taxes and administratively set prices for public services (such as train tickets) or subsidies.
Inflation as an “ongoing process of price increases”
Figure 1 plots the CPI, indexed to 100 in 1982 and the price of WTI oil in USD per barrel, which attracts particular attention when discussing inflation. While Figure 1 suggests that the slope of the CPI line is smooth, suggesting that the CPI captures inflation very well, and that there is little relationship between the two series, looking more closely at shorter time periods shows that this is not always the case. Figure 2 shows that price level shocks can have a large impact on the CPI. The occurrence of price level shocks thus implies that computing the percentage change in the CPI is unlikely to provide a clear view of the “ongoing process of price increases” that constitutes inflation. How can these shocks be removed?
Assessing inflation in real time
How can one obtain a measure of the trend increase in prices in real time? One way to do so is to measure the general level of prices using “core inflation,” that is, using the CPI but disregarding the volatile food and energy components. Another possibility is to use the measure of median inflation intended to capture the trend of prices published by the Federal Reserve Bank of Cleveland. It can be constructed by computing the monthly percent change of all the components of the CPI, ranking them in order from high to low and selecting the middle one.
What do core and median inflation have to say about recent CPI inflation? Between 2011 and 2019 median inflation rose gradually from 2% to almost 3%. The Fed began tapering bond purchases in early 2014, started to increase interest rates in late 2015 and raised them progressively until the summer of 2019, when the weakening economy led it to cut rates. Since inflation lags the business cycle, inflation subsequently fell.
Turning to the current situation, while the CPI and core CPI rose sharply in recent months before peaking, the median inflation has risen more modestly. This illustrates how median inflation is a useful complement to CPI inflation in analysing price pressures and is one reason why many economists and central banks are not overly worried about the recent uptick in prices. Nevertheless, rising median inflation is one more factor motivating a shift towards tighter monetary policy in the US.
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