Inflation Confusion

As opinion about rising food prices and the consequences thereof divides between “the Fed did it” and “the fundamentals did it” camps, I am reminded of the tricky nature of the semantics of any discussion about “inflation.”

In case you need convincing of that yourself, take a look at the results of the most recent Pew News IQ Quiz. Of 13 multiple-choice questions on the quiz, the question that received the fewest correct answers was whether the national inflation rate reported by the government (as of November 2010, when the poll was taken) was closer to 1 percent, 5 percent, 10 percent, or 20 percent. Only 14 percent of the 1001 adults surveyed knew that the answer was 1 percent; more people knew David Cameron is the prime minister of the United Kingdom.

That response does not indicate a general lack of knowledge about economic issues. Seventy-seven percent of respondents knew the deficit is larger now than in 1990s, 64 percent know that the United States runs a trade deficit, and 53 percent are aware that the current unemployment rate is closer to 10 percent than 5 percent or 15 percent. What I think the failure to identify the reported inflation rate probably represents is slippage between the definition of inflation that the average person has in mind and the definition that economists and central bankers are so intently focused upon.

That distinction was the topic of a speech given by Atlanta Fed president Dennis Lockhart earlier today, in which he said:

“In the most recent FOMC statement, following the January meeting, the committee acknowledged the rise of commodity prices, but stated that ‘measures of underlying inflation have been trending downward.’

“Yet inflation anxiety is rising. There seems to be a disconnect between what the Fed is saying and what people are experiencing when they fill up their gas tanks or read about rising food prices around the world.… Are the Fed and the public on different planets?

“Certainly not. But I do think in the swirl of official statements and public discourse we may be talking about different things. To my way of thinking, the term ‘inflation’ is misused in describing rising prices in narrow expenditure categories (for example, food inflation). Nonetheless, recent price news has encroached on the public consciousness with the effect that any price rise of an important consumption item is often taken as signaling inflation.”

The key distinction is the one between the ideas of “the purchasing power of money” and “the cost of living.” Again, quoting President Lockhart:

“Let’s review what inflation is and is not. Inflation affects all prices. Inflation is not the rise of individual prices or the rise of categories of prices.

“I want to contrast inflation to the cost of living. In casual language, we often interpret a rise in the cost of living as inflation. They are not the same thing. Cost-of-living increases are a result of increases in individual prices relative to other prices and especially relative to income. These relative price movements reflect supply and demand conditions and idiosyncratic influences in the various markets for goods and services. If some component of a household’s cost-of-living basket goes up in price, the higher cost of living is not ipso facto inflation.”

When food prices rise or oil prices rise, people are right to feel in some sense worse off, because they are. And if you are tempted to call that “inflation,” I understand. But for policy purposes, the distinction between cost of living increases and inflation as a deterioration in the generalized purchasing power of money is critical. President Lockhart explains:

“In principle, the central bank could respond to the impact of rising costs in particular markets, but only by exerting downward pressure on the dollar price of all goods and services. Monetary policy is a blunt instrument without the capacity to systematically influence prices in targeted markets. Because monetary policy affects the value of the dollar across the board, the targeted item would still be expensive relative to income and relative to everything else.

“…The Fed, like every other central bank, is powerless to prevent fluctuations in the cost of living and increases of individual prices. We do not produce oil. Nor do we grow food. Or provide healthcare. We cannot prevent the next oil shock, or drought, or a strike somewhere—events that cause prices of certain goods to rise and change your cost of living.

“So monetary policy is not about preventing relative price adjustments dictated by market forces. It is about controlling the broad direction and pace of change of all prices across the economy.

“If monetary policy cannot reliably control the cost of living, what is the point? The point is bringing some certainty to planning and long term decision making of individuals and institutions. This is my third basic point. The benefit of price stability—low and stable long-term inflation—is that it reduces the risk associated with longer-term decision-making and avoids the drag on the economy that uncertainty creates.”

There are those, of course, who argue that current policy is, in fact, a source of long-term uncertainty. I will save my commentary on that assertion for a follow-up post.