Why Measuring Inflation Is Such a Tricky Business: Q&A

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Why the Inflation Soft Patch Might Last a Bit Longer

For years after the 2008 financial crisis, politicians and economists parsed every blip in unemployment statistics, searching for signs of full recovery. Now that global unemployment has fallen, inflation has become the hottest indicator. Bond investors pick through the data for trends that could jolt the market even as U.S., European and Asian policy makers puzzle over why the readings have remained so low, as they were again in July. And inflation measures come in many flavors -- central bankers like to sample them all. That’s why it’s crucial that economy-watchers understand how the various gauges are compiled and used.

1. Why are there multiple inflation gauges?

They measure different things. Let’s start with the U.S. Federal Reserve’s go-to numbers. The Fed officially favors a gauge of personal consumption expenditures reported by the Commerce Department. PCE tracks things that are consumed by Americans, including those they don’t directly pay for, like Medicare-funded health care. The Consumer Price Index -- a separate Labor Department measure -- tracks the prices of goods and services bought by people living in urban areas. Fed watchers still follow CPI closely, because it comes out earlier and it’s fundamentally important to the PCE. About 70 percent of the item categories included in Commerce’s PCE gauge are price-adjusted using Labor’s CPI data. (For the real wonks out there, Commerce reconciles the two gauges each month.)

2. What measures do Europe and Japan watch?

The European Central Bank targets year-on-year increases in the Harmonised Index of Consumer Prices, while the Bank of Japan closely watches its own CPI data excluding fresh food, though monetary policy leaders say that they look at various gauges and even wages to get a feel for price momentum.

3. And what about these inflation ‘flavors’?

There’s headline inflation, which includes changes in food and energy prices, while core inflation leaves those items out because they’re prone to short-term spikes. The Fed officially looks for headline data, though they often reference core and generally watch it more closely. The reason for the discrepancy? Core gives a better sense of the trend, but it’s a political non-starter for monetary policy makers to act like people neither eat nor drive.

4. So what’s puzzling about today’s inflation numbers?

Something’s funky. Most major economies aim for stable inflation at or near 2 percent. That’s proved elusive. In the U.S., price gains have decelerated since the start of 2017, and the same is true in Europe. The tepid gains are a little bit surprising.

5. Why surprising?

Because they aren’t following the playbook. Economists have long believed in a relationship between unemployment and inflation called the Phillips Curve. The basic idea is that as joblessness drops, employers have to offer better wages to attract workers. Then prices should tick higher as businesses try to cover their costs by passing them on to consumers, and as households spend the higher wages, ramping up demand. Despite falling unemployment across the developed world, a variety of inflation measures show next to no pickup.

6. What do consumers think about the numbers?

Shoppers almost always feel like inflation is higher than the data suggest. In Germany, you hear talk of “perceived inflation,” an idea promoted years ago by an economics professor, Hans Wolfgang Brachinger, who said people are more sensitive to price changes on goods the buy frequently and thus have a skewed perception of the inflation trend. In the U.S. and in Europe, consumers consistently overestimate price gains in surveys. 

7. Do policy makers care what consumers think?

Oh yes. When it comes to inflation, expectation leads reality, so monetary policy makers watch both the market and consumer inflation outlook closely. The market expectation can seen by examining break-evens -- the difference between the yield of a plain-vanilla government bond and an inflation-indexed bond of the same maturity. The ECB closely watches a version of this in a rate that tracks expected inflation starting five years from now. The Fed pays attention to a similar measure, along with consumer survey-based expectations from the University of Michigan and the New York Fed.

8. So what does a monthly change in inflation really mean?

It’s what’s inside that change that counts. While it’s impossible to tell for sure whether a swing will turn into a trend, the underlying details offer hints. If the mobile phone plan index shows a big decline, as it did earlier this year, that’s most likely not going to persist in the monthly data. By contrast, tepid price gains across a swath of services, like the recent slowdown in health-care prices and housing costs, might be something to worry about. Such declines could be signs that weaker inflation is more than just temporary.

The Reference Shelf

— With assistance by Jana Randow, Toru Fujioka, and Enda Curran

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