Tuesday, May 15, 2018

How Central Banks Differ In Their Methods Of Calculating Inflation

My last two posts covered the uncertainty about the natural rate of unemployment. That is the lowest rate of unemployment compatible with price stability or a low level of inflation. That implies that, if the policy makers try to get the unemployment rate too low, the inflation rate will go over some target, like 2% (the Fed's target).

But it also appears that there is no "right" way to calculate inflation. See Lies, Damn Lies and Inflation: CPI figures have different meanings in the U.S. and Europe, thanks to different treatment of housing and health care by James Mackintosh of The WSJ. Excerpt:
"It is less well understood that the inflation figures have quite different meanings, thanks to different treatment of housing and, to a lesser extent, health care. The most dramatic difference is housing: In the U.S., shelter makes up a third of the consumer-price index, because it includes an imputed rent for homeowners. In Europe only actual rents are measured, at a weight of just 6% of the basket of goods and services underlying the price index.

Measure both using the European approach, and overall prices have risen the same amount since 2011. It is true that using this measure—known as the harmonized index of consumer prices, or HICP—U.S. prices have risen faster since last summer. But that appears to be in large part due to energy, where the weak dollar has pushed oil prices up faster than in Europe. There aren’t any detailed breakdowns available for U.S. HICP, which is still an experimental statistic, but the CPI excluding shelter, food and energy is the best equivalent to core eurozone inflation, and exactly the same at 1.2%.

Another indication of the importance of housing comes from the Cleveland Fed’s median CPI, which takes the middle price rise from a ranking of the CPI components. It drops from 2.6% to 1.7% when imputed rents are excluded, although in recent months it, too, has accelerated.

The Fed’s preferred inflation gauge, the PCE price index, takes a sixth of its weight from rent and imputed rent. The gap from CPI weights is made up mostly by including employers’ health-care costs to get a health-care weight of a fifth. In Europe the equivalent health-care costs, mostly borne by government, are ignored in HICP, and booze and smokes are almost as important as health-care in determining inflation.

Statisticians have argued for years about how to include housing costs, and they keep changing their minds. The Swedish central bank switched its target last year to a different measure of inflation in order to exclude mortgage rates, while the British statistical agency last year started promoting a measure of inflation including imputed rents, with mixed success."

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