The Pseudo Science of Inflation

COMMENTARY Budget and Spending

The Pseudo Science of Inflation

Aug 6th, 2014 3 min read
Norbert J. Michel, Ph.D.

Senior Research Fellow

Norbert Michel studies and writes about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.

Many economists were quick to jump all over the Federal Reserve for its expansionary monetary policies surrounding the 2008 financial crisis. After its typical open-market purchases did little to get the economy moving again, the Fed embarked on several rounds of quantitative easing (QE), the most expansive policies it has ever orchestrated.

The fear has always been that expanding the monetary base as rapidly as the Fed did would lead to incredibly high price increases — perhaps even  hyperinflation. While the precise reason may be debatable, it’s clear that we haven’t yet experienced hyperinflation in the U.S. Perhaps we’re just lucky.

Regardless, the reprieve from hyperinflation hasn’t stopped the argument over exactly how much inflation we do have, or how to measure it.

It would be helpful if we could apply a purely scientific concept to inflation. A formula, perhaps, equivalent to the chemical formula for water. Two parts hydrogen, one part oxygen – always has been, always will be.

But economics is not comparable to the physical sciences this way, and inflation is a great example. What is inflation? It’s a rise in the general price level. What’s the general price level?

That’s where things get troublesome.

The general price level is a man-made construct for which no natural scientific formula exists. The best that we can do is describe the price level by gathering tons of price data to derive some sort of estimate. By its very nature, this exercise can only generalize the billions of prices that actually exist in the economy.

And anyone can see that as soon as this estimation exercise is complete, there’s a new price level. Theoretically, the price level that likely matters most is the one that individuals expect. But that price level is indeterminate because it is literally whatever people think it is.

Nonetheless, macroeconomists need a price level — a variable represented by P — for their models. This fact explains why policymakers go through their estimation process, but the truth is there’s no objective process and, therefore, no objective measure. There’s no way we can objectively point to “the right” inflation measure.

In the world that we’ve created, though, the Fed hast to judge whether inflation is too high. So what’s the best measure? Is it the Personal Consumption Expenditure index (PCE) or the Consumer Price Index (CPI)?

The difference between these two measures is frequently close to one full percentage point, a major discrepancy when the Fed’s inflation target is 2 percent.

Or, instead, perhaps the best measure is core inflation, a price-level measure that omits food and energy prices? There’s a valid statistical problem, though: food and energy prices tend to be more volatile than other consumer prices.

This problem is of little consequence to consumers when they pay their bills.  However, policymakers at the Fed are trying to gauge what their policies have done (and will do) to the general price level, so using a core measure does make some sense.

Even if we could agree on what the best inflation measure is, then we get into an even murkier debate – what should policymakers do about it?

As columnist Megan McArdle recently noted:

“ As with unemployment, there are two different, and equally valid, questions we could be asking when we look at inflation statistics:

• Are people finding it harder to maintain their standard of living?

• Is monetary policy too tight or too loose?

These are actually very different questions, which doesn’t mean that one is more important than the other. The Fed is interested in whether there is too much money in the system, which would show up as a broad increase in all prices.

McArdle is right, these are two different questions, and it’s not clear that one is more important than the other. (See Dallas Fed President Richard Fisher’s Wall Street Journal op-ed.)

But is it really true that “too much money in the system … would show up as a broad increase in all prices”? Hyperinflation would definitely work that way, but there’s no clear line between hyperinflation and high inflation, and there’s no objective law that says when any particular prices would respond.

The economic theory that connects “the price level” to broad macroeconomic outcomes produces nothing remotely similar to the reliability of the chemical formula for water. There’s actually no reason that too much money in the system can’t show up as price increases in various segments of the economy, some before others.

And since the Fed is charged with moderating inflation, it has to pay attention to whether people are finding it harder to maintain their standard of living. It doesn’t matter that it’s nearly impossible to separate the effects of drought, political turmoil, and monetary policy on commodity prices, and it makes no difference that the Fed can’t really do anything except turn the flow of credit on or off.

All the Fed really has tight control over is the monetary base. In other words, the Fed can print money like crazy but once it’s out, the Fed can’t control where it goes.

But we’ve created a system that requires the Fed to try to moderate inflation, and the consequences could end up much worse than the problem itself. The question Congress should be asking is: What happens when we charge the central bank with trying to control things it really can’t control?

 - Norbert Michel is a Research Fellow in Financial Regulations at The Heritage Foundation.

Originally appeared in Forbes

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