Alternative Measures of Inflation (Part 2): Inflation Versus the Cost of Living

by Mike Bryan – Federal Reserve Bank of Atlanta

Let me make two claims that I believe are, separately, uncontroversial among economists. Jointly, however, I think they create an incongruity for how we think about and measure inflation. The first claim is that over time, inflation is a monetary phenomenon. It is caused by too much money chasing a limited number of things to buy with that money. As such, the control of inflation is rightfully the responsibility of the institution that has monopoly control over the supply of money – the central bank.

My second claim is that the cost of living is a real concept, and changes in the cost of living will occur even in a world without money. It is a description of how difficult it is to buy a particular level of well-being. Indeed, to a first approximation, changes in the cost of living are beyond the ability of a central bank to control.

For this reason, I think it is entirely appropriate to think about whether the cost of living in New York City is rising faster or slower than in Cleveland, just as it is appropriate to ask whether the cost of living of retirees is rising faster or slower than it is for working-aged people. The folks at the Bureau of Labor Statistics produce statistics that can help us answer these and many other questions related to how expensive it is to buy the happiness embodied in any particular bundle of goods.

But I think it is inappropriate for us to think about inflation, the object of central bank control, as being different in New York than it is in Cleveland, or to think that inflation is somehow different for older citizens than it is for younger citizens. Inflation is common to all things valued by money. Yet changes in the cost of living and inflation are commonly talked about as if they are the same thing. And this creates both a communication and a measurement problem for the Federal Reserve and other central banks around the world.

Here is the essence of the problem as I see it: money is not only our medium of exchange but also our numeraire—our yardstick for measuring value. Embedded in every price change, then, are two forces. The first is real in the sense that the good is changing its price in relation to all the other prices in the market basket. It is the cost adjustment that motivates you to buy more or less of that good. The second force is purely nominal. It is a change in the numeraire caused by an imbalance in the supply and demand of the money being provided by the central bank. I think the concept of “core inflation” is all about trying to measure changes in this numeraire. But to get there, we need to first let go of any “real” notion of our price statistics. Let me explain.

As a cost-of-living approximation, the weights the Bureau of Labor Statistics (BLS) uses to construct the Consumer Price Index (CPI) are based on some broadly representative consumer expenditures. It is easy to understand that since medical care costs are more important to the typical household budget than, say, haircuts, these costs should get a greater weight in the computation of an individual’s cost of living. But does inflation somehow affect medical care prices differently than haircuts? I’m open to the possibility that the answer to this question is yes. It seems to me that if monetary policy has predictable, real effects on the economy, then there will be a policy-induced disturbance in relative prices that temporarily alters the cost of living in some way.

But if inflation is a nominal experience that is independent of the cost of living, then the inflation component of medical care is the same as that in haircuts. No good or service, geographic region, or individual experiences inflation any differently than any other. Inflation is a common signal that ultimately runs through all wages and prices.

And when we open up to the idea that inflation is a nominal, not-real concept, we begin to think about the BLS’s market basket in a fundamentally different way than what the BLS intends to measure.

This, I think, is the common theme that runs through all measures of “core” inflation. Can the prices the BLS collects be reorganized or reweighted in a way that makes the aggregate price statistic more informative about the inflation that the central bank hopes to control? I think the answer is yes. The CPI excluding food and energy is one very crude way. Food and energy prices are extremely volatile and certainly point to nonmonetary forces as their primary drivers.

In the early 1980s, Otto Eckstein defined core inflation as the trend growth rate of the cost of the factors of production—the cost of capital and wages. I would compare Eckstein’s measure to the “inflation expectations” component that most economists (and presumably the FOMC) think “anchor” the inflation trend.

The sticky-price CPI

Brent Meyer and I have taken this idea to the CPI data. One way that prices appear to be different is in their observed “stickiness.” That is, some prices tend to change frequently, while others do not. Prices that change only infrequently are likely to be more forward-looking than are those that change all the time. So we can take the CPI market basket and separate it into two groups of prices—prices that tend to be flexible and those that are “sticky” (a separation made possible by the work of Mark Bils and Peter J. Klenow).

Indeed, we find that the items in the CPI market basket that change prices frequently (about 30 percent of the CPI) are very responsive to changes in economic conditions, but do not seem to have a very forward-looking character. But the 70 percent of the market basket items that do not change prices very often—these are accounted for in the sticky-price CPI—appear to be largely immune to fluctuations in the business conditions and are better predictors of future price behavior. In other words, we think that some “inflation-expectation” component exists to varying degrees within each price. By reweighting the CPI market basket in a way that amplifies the behavior of the most forward-looking prices, the sticky-price CPI gives policymakers a perspective on the inflation experience that the headline CPI can’t.

Here is what monthly changes in the sticky-price CPI look like compared to the all-items CPI and the traditional “core” CPI.

Let me describe another, more radical example of how we might think about reweighting the CPI market basket to measure inflation—a way of thinking that is very different from the expenditure-basket approach the BLS uses to measure the cost of living.

If we assume that inflation is ultimately a monetary event and, moreover, that the signal of this monetary inflation can be found in all prices, then we might use statistical techniques to help us identify that signal from a large number of price data. The famous early-20th-century economist Irving Fisher described the problem as trying to track a swarm of bees by abstracting from the individual, seemingly chaotic behavior of any particular bee.

Cecchetti and I experimented along these lines to measure a common signal running through the CPI data. The basic idea of our approach was to take the component data that the BLS supplied, make a few simple identifying assumptions, and let the data itself determine the appropriate weighting structure of the inflation estimate. The signal-extraction method we chose was a dynamic-factor index approach, and while we didn’t pursue that work much further, others did, using more sophisticated and less restrictive signal-extraction methods. Perhaps most notable is the work of Ricardo Reis and Mark Watson.

To give you a flavor of the approach, consider the “first principal component” of the CPI price-change data. The first principal component of a data series is a statistical combination of the data that accounts for the largest share of their joint movement (or variance). It’s a simple, statistically shared component that runs through all the price data.

This next chart shows the first principal component of the CPI price data, in relation to the headline CPI and the core CPI.

Again, this is a very different animal than what the folks at the BLS are trying to measure. In fact, the weights used to produce this particular common signal in the price data bear little similarity to the expenditure weights that make up the market baskets that most people buy. And why should they? The idea here doesn’t depend on how important something is to the well-being of any individual, but rather on whether the movement in its price seems to be similar or dissimilar to the movements of all the other prices.

In the table below, I report the weights (or relative importance) of a select group of CPI components and the weights they would get on the basis of their contribution to the first principal component.

While some criticize the CPI because it over weights housing from a cost-of-living perspective, it may be these housing components that ought to be given the greatest consideration when we think about the inflation that the central bank controls. Likewise, according to this approach, restaurant costs, motor vehicle repairs, and even a few food components should be taken pretty seriously in the measurement of a common inflation signal running through the price data.

And what price movements does this approach say we ought to ignore? Well, gasoline prices for one. But movements in the prices of medical care commodities, communications equipment, and tobacco products also appear to move in ways that are largely disconnected from the common thread in prices that runs through the CPI market basket.

But this and other measures of “core” inflation are very much removed from the cost changes that people experience on a monthly basis. Does that cause a communications problem for the Federal Reserve? This will be the subject of my final post.

About the Author

By Mike Bryan, vice president and senior economist in the Atlanta Fed’s research department

Source: http://macroblog.typepad.com/macroblog/2014/06/torturing-cpi-data-until-they-confess-observations-on-alternative-measures-of-inflation-part-2.html