Does the European Central Bank target the wrong inflation-metric – and therewith overstate inflation?
from Merijn Knibbe
Economists are asking why, considering the ‘output gap’ (read: high and increasing unemployment), inflation isn’t lower. Part of the answer: economists are looking at the wrong metric. The consumption price level indeed does not seem to respond to the increasing output gap. But other price levels do. Average inflation is lower than before the crisis, contrary to consumer price inflation. Which means that monetary policy is more restrictive than generally understood (while consumers pay the bill).
The European Central Bank targets the inflation of the HICP, the Harmonized Index of Consumer Prices. This index tracks the (average) increase of consumer prices and therewith, more or less, the price of an ‘average’basket of consumer goods and the purchasing power of household income. Tracking purchasing power of households is of course extremely important. However, consumer expenditure is not the only kind of expenditure. Investments are an example of another kind of expenditure, just like exports and government expenditure. As the price level for investments (which includes investments in new homes) includes land prices and as land prices (take Ireland, Spain or the Netherlands as recent examples) can develop entirely different from for instance oil prices, surely in the case of booms and busts, while prices of investment goods are more volatile than consumer prices anyway, investment price inflation can show developments entirely different from the development of consumer prices. Which means that the change of the ‘average’ price level of the entire economy, can differ substantially from the consumer price index. It can. But does it? Yes. I’ll take Dutch data (national accounts 2011, published today) as an example because I’m most familiar with this information - but I expect the pattern shown by these data to be rather representative, as much of the developments which are taking place in the Netherlands are also taking place in quite some other Eurozone countries.
The data enable a comparison of domestic and imported inflation as well as a comparison between different kinds of domestic inflation (graph 1 and 2).
There is no way in which the ECB can combat imported inflation (oil prices) – so it shouldn’t. Which leaves us with total domestic inflation (GDP inflation) – which is quite a bit lower than consumer price inflation. The ECB should have taken of such differences during the bubble years – and they should take account of this at the moment. But, at least according to official statements, they don’t.