Inflation Statistics Can Deceive You - Don't Trust Them

by: Accrued Interest

The Big Picture, authored by Barry Ritholtz, is one of the most popular investment blogs going, and I often find Barry's work enlightening. But his obsession with "inflation ex-inflation" has got to stop. There are some good comments from Brad DeLong and KNZN on their respective blogs, but I feel compelled to chime in.

A central bank's job is to manage the money supply. Anything that has nothing to do with the money supply isn't the Fed's job. Keep that in mind.

Now let's assume that quantity demanded for a given good is expressed as a function of...

D = f (P, O, T, Y)

Where P is the price of the good, O is the price of other goods (compliments and substitutes), T is consumer tastes and preferences, and Y is nominal income. Note that Y is the only variable that would impact all goods in the same direction at the same time.

Thinking about the classic demand curve, changes in P cause movement along the demand curve, while O, T, and Y cause the demand curve to shift. Hopefully most of AI's readers took freshman microeconomics, and this all seems very elementary.

Now let's say that preference for some good, say corn, rises. Maybe Congress has increased the subsidy for ethanol, let's just say. Supply of corn is short-term inelastic, because it takes time to plant and harvest new corn crop. So the demand curve shifts outward, supply doesn't change much (if at all) and therefore the price of corn rises.

Now consumers of corn for food (as opposed to ethanol) will probably rotate into other food products, to the extent that corn has substitutes. So demand for wheat might expand, due to the O factor. And since wheat probably also has a fairly inelastic short-term supply curve, the price of wheat also rises.

So we have food prices rising, but having nothing to do with the money supply. Therefore reacting to this chain of events ain't the Fed's job. It makes no more sense to ask the farmer where to peg overnight bank loans than to ask the Fed to control agriculture prices.

Inflation comes from an increase in the money supply. If there is just more money floating around, this would manifest itself as a increase in Y. And remember that Y impacts all goods at the same time in the same direction. Perhaps not to the same extent, but at least in the same direction.

So let's say that in conjunction with the rising price of corn, the effective money supply has also expanded by 5%. Everyone has 5% more to spend, which causes all prices to rise by 5%. But corn and other food products actually rise by more than 5%, because of the shift in tastes. And somewhere some other price has to fall, or not rise as much, because the extra money being spent on food isn't getting spent someplace else.

Anyway, the Fed's problem is the 5% expansion in the money supply, not the increased demand for corn. Unfortunately, its difficult to peg exactly what the effective money supply is. And in real life, all goods face constantly shifting supply and demand curves. So the Fed faces a challenge in determining whether the money supply is increasing at a faster or slower rate than is desired.

In a perfect world, the Fed would look at a subset of goods for which O, T and the supply curve were all constant. It really wouldn't matter how representative those goods were, because the only thing that would cause the price to shift would be Y. The Fed could then determine if the change in price of this basket of goods was optimal knowing that the price change was due to changes in the money supply.

Of course, in real life, no such products exist. So the next best option is to strip out products which are known to have unstable supply and demand curves. This was originally the impetus for creating the "Core" CPI and PCE measures. Another way to handle this is to assume that the most volatile prices in a given period are being influenced by good-specific supply and demand factors and strip those out, whatever they might be. This is the idea behind the Dallas Fed's Trimmed Mean PCE and the Cleveland Fed's Median CPI estimate.

If the Fed is going to pick an inflation measure to target, we want them to target something that in most closely aligned with shifts in money supply and shifts in money supply alone.

Its fair for someone to say that their household bills are rising at a faster rate than any of the core inflation measures. Some of the items that have been rising in price most lately have been repeat consumables, like gas and food. But the Fed isn't targeting cost-of-living. It can't.

So if you want to blame the media for ignoring cost of living in reporting on "core" inflation measures, fine. But don't blame the Fed.