The Fed Should Target Inflation

It’s a pretty well-established fact that the public thinks inflation is higher than the official statistics show.  I believe that’s because the public thinks of the “cost of living” in a slightly different way from how economists think of the term.  If the average phone bill was $30/month in 1970 and its $60/month today, then people think the cost of phone service has doubled, even if the price of a long distance call has fallen by 99%.  If popular models of color TVs now cost the same $400 as in 1960, then the price is unchanged in the public’s mind, even if the BLS says TV prices are down by 90%.  Only for items like gasoline do the public and BLS agree.

To the public, the “cost of living” is the amount of income you need to have a normal lifestyle.  What’s a normal lifestyle?  Roughly the lifestyle of your neighbors. And since both income and consumption tends to rise a bit faster than the CPI, the public’s estimates of the rate of inflation are slightly higher than the BLS’s estimate.  (I’m cheating a bit here; I actually think the public is composed of a mixture of people who understand what the BLS is measuring, and those who don’t.)

Let’s say the public does think of the cost of living in terms of the amount of money needed for an average lifestyle.  In that case, what variable should the Fed stabilize?  Obviously growth in average incomes.  And if population growth is fairly steady at 1% per year, then one way of stabilizing average per capita income growth at 4% per year, would be to set a 5% NGDP target.

So the public actually favors NGDP targeting, they just don’t know it.

BTW, if my theory were correct then the Chinese people should believe that the cost of living in China is rising really, really fast, even though the inflation data shows a very slow rise in prices. That’s because nominal incomes are rising very fast in China.

And they do!  It may be hard to believe, but the Chinese people were complaining bitterly about inflation back in 2010, when the Chinese CPI was rising by 2.7% and their nominal incomes were soaring at double digit rates.

It’s all about “keeping up with the Zhangs.”

• Become A Funded Futures Trader