Why Measuring Inflation Is Such a Tricky Business: QuickTake

BlackRock's Rieder Says U.S. Inflation Is 'Just Not That Scary'

Something’s funky with inflation. Economists studying the statistics that measure how fast prices increase were puzzled when inflation slowed in 2017, both in the U.S. and in Europe. That’s because as global economic growth recovered and unemployment fell, gains should have been climbing toward the 2 percent level that most major economies target. While U.S. price gains have been slowly rebounding, inflation remains below the Federal Reserve’s goal. The same is true in much of Europe. This has prompted a deeper look at what’s reining in the various inflation gauges.

1. What’s puzzling about the figures?

They haven’t been 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 pass the extra costs on to consumers and as households spend their higher wages, ramping up demand. Despite falling unemployment across the developed world, both pay gains and a variety of inflation measures have been slow to take off.

2. Why has inflation been so weak?

No one knows. There are a few possible suspects: Amazon’s low prices could be keeping other prices down; there might have been more unemployed people looking for work than had been counted; and threats to move jobs to countries with cheaper labor could be keeping pay down in industrial nations. Others think that the relationship between unemployment and inflation still holds, it’s just a lot slower to kick in these days. That seems consistent with the latest data: Prices have been tiptoeing higher in places with especially strong job markets. Many U.S. economists expect inflation to move toward or even above 2 percent in 2018. In the U.K., inflation is now actually running well above the Bank of England’s target.

3. Where do policy makers look for clues?

Often at what’s driving the figures. While it’s impossible to tell for sure whether a swing in overall prices will turn into a trend, detailed breakdowns of sub-indexes can offer hints. If the measure tracking mobile phone plan pricing shows a big decline, as it did in 2017, this might not persist in the data. By contrast, tepid price gains across a swath of categories, like health and housing, might be the sign of a genuine slowdown. That could have implications for interest rates, which are on the rise in some parts of the world.

4. 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, or PCE, reported by the Commerce Department. PCE tracks things that are consumed by Americans, including those they don’t directly pay for, like Medicare, the government-funded health-care plan for the elderly. The consumer price index, or CPI, is a Labor Department measure that tracks the prices of goods and services bought by people living in urban areas. Fed watchers follow that number closely, because the data come out earlier and about 70 percent of the categories included in the PCE gauge are price-adjusted using CPI data. (For the real wonks out there, Commerce reconciles the two gauges.)

5. Does every country watch the same measures?

No. The European Central Bank targets year-on-year increases in the Harmonized Index of Consumer Prices (“harmonized” because all European Union countries calculate it the same way). The Bank of Japan closely watches its own CPI data excluding fresh food. Interest-rate setters say that they look at various gauges and flavors to get a broad feel for price momentum.

6. What are 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 its officials often rely on 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 policy makers to act like people neither eat nor drive.

7. Do consumers think of inflation differently?

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

8. Do policy makers care what consumers think?

Oh yes. When it comes to inflation, expectation leads reality. The Fed pays attention to surveys of consumers’ outlook from the University of Michigan and the New York Fed. Policy makers also watch market bets on where inflation is headed 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 Reference Shelf

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

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