October 1, 2014 | Commentary on Economy, Economic Analysis, Macroeconomy

The Pseudoscience of Inflation: Part II

A few weeks back this column discussed some of the basic problems with measuring inflation in the macro economy.  It pointed out that economists use several different price indices because there’s no one, purely objective way to measure inflation.

It’s nothing like measuring the volume of water in a container or the chemical makeup of a natural substance.  Still, we live in a world where government agencies have to measure inflation, so it’s not surprising that people complain about how badly the Fed or the BLS misses the mark.

These complaints recently got louder when the Fed decided to keep its interest rate target at or near historic lows.  The announcement made people nervous – rightfully so – because if the Fed gets it wrong, too much money can lead to too much inflation, something nobody really wants.

So, now, on to part II.

Let’s examine two key differences between the well-known Consumer Price Index and the Fed’s favorite measure, the Personal Consumption Expenditure index.  (For those so inclined, these articles provide a much more detailed look at all the differences.)

Two of the main differences are referred to as the “weight effect” and the “scope effect.” These differences arise because the two indices are conceptually different and therefore draw on different data sources.

The CPI measures out-of-pocket spending by urban dwelling households.  The PCE is designed to measure household and nonprofit spending as a component of the National Income and Product Accounts (NIPAs).

Because the NIPAs are compiled to measure GDP, an estimate of final goods and services sales, the PCE is largely dependent on business surveys.  The CPI, on the other hand, relies on household surveys.

As a result, the relative weights given to the various items in the CPI and the PCE are different.  This discrepancy is the weight effect.

Similarly, some items included in the CPI are not included in the PCE, and vice versa.  This difference is known as the scope effect because some items in one index are “out of scope” for the other index.

For example, CPI healthcare expenditures include only consumers’ out-of-pocket spending on medical care.  PCE healthcare spending, on the other hand, includes all such spending paid for by consumers, as well as those paid for on behalf of consumers.  (Mainly Medicare, Medicaid, and employer-provided insurance).

In past studies, the weight and scope effects have accounted for similar shares of the discrepancy  between the CPI and the PCE index.

These differences have caused a great deal of needless hand-wringing over which index does a better job of measuring inflation.  The measures are conceptually different, so they both have strengths and weaknesses relative to any ideal statistic.  Besides, both measures tend to track each other very closely over time, whether measured on a monthly or annual basis. (Even alternative indices, such as MIT’s “billion prices index” seem to track the PCE and CPI fairly well.)

Beyond the weight and scope effects, additional issues complicate the question of which is a better measure of inflation.  For instance, both indices weigh housing costs differently and both focus on the goods and services sector while largely ignoring financial asset prices.

To whatever extent inflation flows through these assets, both indices can paint an inaccurate picture of inflation.

Perhaps worse, fixing all of these issues wouldn’t really address a commonly heard complaint among the general public: official inflation measures fail to capture the rising cost of living.  In fact, both the BLS and the BEA openly acknowledge their inflation measures are not cost of living indices.

 Many people may not be familiar with the conceptual differences between price indices and cost of living indices, but they frequently notice that official inflation measures don’t match their own expenditures.

One recent article pointed out that, even though the core CPI indicated there was no inflation, food prices were up almost 3 percent, with some food items up even more.

“From July to August, the 'Core Consumer Price Index' did not move. That means zero inflation, if you use the measure of inflation the Federal Reserve uses when setting monetary policy. But core CPI omits volatile prices like food and energy. If you have a family, you’re probably pretty aware that food and utility bills are a big factor."

Food at home is up 2.9 percent. Our grocery bill is about tied with our mortgage for our highest expense. Also, the types of groceries we spend the most on are up even more: Meat prices are up 8.8 percent.

These kinds of variations can exist within any price index, regardless of scope and weighting effects.  Some prices rise, some fall, and the differences can average out so that overall prices show very little change.  Choosing the “best” inflation metric, therefore, would not solve the man on the street’s problem.

The article goes on to lament:

“The net result is that life has gotten considerably more expensive for me since this time last year. I’m not saying this ought to guide our monetary policy. I’m just saying that core CPI doesn’t track the cost of living."

No, it frequently doesn’t.

So what should the Fed be using to track inflation?  Should they use a cost of living index, focus on a core inflation index, or use a broad PCE or CPI?

There’s no objective scientific formula to help us, and there’s simply no perfect solution.  But should we allow the lack of a perfect solution to be the enemy of a good solution?

Is it good to allow the Fed to shoot for an inflation target based on whichever combination of inflation metrics it chooses?  Perhaps the most important improvement to monetary policy would be to force the Fed to adhere to some sort of Taylor rule or NGDP target?

Alternatively, might we be better served to stop the Fed from actively targeting inflation?  Maybe go back to the classic gold standard?

One reason some economists argue we should stop the Fed from actively targeting inflation – even via a policy rule – is that it can never truly be held accountable for any macro aggregates other than the monetary base.

The Fed can always, for example, blame inflation on external factors beyond its control.  The same is true for changes in unemployment, asset prices and even most measures of the money stock.

The only exception is the monetary base (currency plus banks’ reserves).  The Fed cannot blame changes to the base on anyone else.

So one alternative policy solution deserves more scrutiny: freeze the monetary base and set financial markets free.  Allowing private banks to issue currency against a frozen base of U.S. dollars, as proposed by Milton Friedman and later expanded by George Selgin, deserves to be part of any monetary policy reform discussion.

There’s certainly no guarantee that inflation will end under any alternative, but we do ourselves a disservice to dismiss the ability of markets to outperform the Federal Open Market Committee.

 - Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

Originally appeared in Forbes