FT.com / Companies / IT - Why nobody wants to see inflation with no clothes on

FT.com / Companies / IT - Why nobody wants to see inflation with no clothes on

Why nobody wants to see inflation with no clothes on
By John Kemp

Published: November 27 2007 02:00 | Last updated: November 27 2007 02:00

The Emperor's New Clothes, Hans Christian Andersen's fairy tale about the fear of challenging mass delusion, is a story with resonance today.

Nowhere in economic debate does such power of perception play a bigger role than in the alleged disappearance of inflation. Central banks have switched the focus of public and media attention away from the full set of "consumer prices" to a subset that excludes some of the fastest-increasing items and therefore understates the true rate of price increases. The US Federal Reserve, for example, focuses on "core inflation" - which excludes food and energy.

There is no harm in focusing on core measures to smooth out month-to-month volatility - provided the core measure and the broader inflation gauges track one another roughly over time. But during the past 10 years the US core rate has been on average 0.3 percentage points lower than the broader one. And the discrepancy is growing. Over the past two years it has been minus 0.7.

There is a perception that central banks are focusing on core measures because they are more expedient. Commentators are querying the reliability of the numbers. For most households, the published inflation rates do not accord with their own experience of rising living costs, causing a growing credibility gap that is fuelling criticism of the data.

The statistical authorities have also been "adjusting" the inflation numbers downwards to take account of improvements in quality. Most people would accept the logic of making quality adjustments for computers. But once they started going down this route, the government's statisticians have found it hard to stop. The US government is now making "hedonic quality adjustments" to a whole range of items: clothes dryers, microwave ovens, camcorders, DVD players, even college textbooks.

The problem is that no one is making any negative adjustments to take account of declines in quality. Because the data are being adjusted only for improvements, never for declines, it is arguably biasing the published inflation numbers downwards.

There is also the problem that published measures of inflation do not include the price of assets. But it is not obvious why they should be excluded. As incomes rise, households start to devote a much higher proportion of their income to the acquisition of assets (from bigger houses to larger stock portfolios and saving plans for retirement and college education). As household consumption patterns shift, so the traditional consumer price index captures a diminishing proportion of expenditure.

Crucially, asset price inflation can create just as many inefficiencies as the inflation in goods and services prices. If all financial asset values are rising rapidly, it may be hard to discern where capital can be employed most profitably, leading to indiscriminate capital allocation.

And as the financial side of the economy has grown in relation to the real one, the potential for instability arising on the financial side to spill over has grown. Excess liquidity has piled into the asset markets. Instead of excess liquidity chasing up the price of goods and services (inflation), it has chased up the price of assets (which is not inflation by the conventional definition).

There is a sense that commentators and policymakers are engaged in the collective delusion of the emperor's new clothes. Excess liquidity created by the Federal Reserve and other central banks during 2001-2005 did indeed result in faster inflation - but in asset prices rather than goods and services. It also created distortions - but in property prices, subprime mortgages and securitisations.

Even as the US housing bubble has deflated, inflationary pressures within the global economy remain strong. High commodity prices are no longer offset by declines in the price of computers, cars or imports from China.

The "death of inflation" was predicted by one economist in the 1990s. He might have characterised it better as the "disappearance" of inflation. The question for policymakers and investors alike is whether and when the little boy will shout from the crowd and break the illusion. If it happened, interest rates would have to be much higher.

The writer is the economist at Sempra Metals
Copyright The Financial Times Limited 2007