Alcidi, Busse and Gros: mistaken about inflation
In an interesting article Cinzia Alcidi, Matthias Brusse and Daniel Gros argue that central banks should not target consumer price inflation but should look at GDP inflation instead. They are right to discuss the target variable of central banks. They are wrong about the alternative. As the GDP deflator (which is used to calculate GDP inflation) is influenced by the terms of trade, it is not a reliable indicator of domestic price developments.
I do not accept the idea that central banks should only look at ‘price stability’. They should look at monetary stability, i.e. price plus financial stability. Whch means that they should not only focus on expenditure price inflation but also on debts, house prices and wage levels, to be able to ‘lean against the wind’ in case of unsustainable asset price booms and subsequent bouts of disastrous wage declines and debt deflation (look here for an article on this). Even then, it is good to have some idea of the development of expenditure prices. As (domestic) expenditure does not only consist of consumer spending but also of investments and government consumption (i.e. expenditure on the NHS in the UK, large chunks of education in almost all countries, the judicial system everywhere etc.) it is wise to look at a metric which is more broadly based than consumer price inflation. The GDP deflator is however not fit for this task (at least in the Euro Area) as it is decisively influenced by the terms of trade, as I show here. Which explains the anomalous increase of this variable in 2011 and 2012. The right expenditure price variable to use is domestic demand inflation (the official Eurostat name is: finan consumption expenditure, gross capital formation and exports of goods and services inflation), which is not influenced by the terms of trade but which does track investment and government consumption prices. The graph clearly shows that domestic demand deflation, as it was less influenced by the increases in VAT which all over Europe kept consumer price inflation high in 2011 and 2012, was, after 2006, would have been a much better guide for the ECB than either consumer price inflation or the GDP deflator. Especially the rapid disinflation after 2010 was captured much faster by this indicator than by the other two. Which of course indicates that the post 2010 tightening policies of the ECB, even when you are so wrong to accept that central banks should only target expenditure prices, were totally misguided. As they looked too much at only one part of expenditure prices.