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Mon Feb 28 11:22:24 PST 2005

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STEERING BY A FAULTY COMPASS
Feb 24th 2005  

Are central banks watching the wrong measure of inflation?

LAST week, for the first time, America's Federal Reserve published its
forecast of inflation over the next two years. Many observers took this
as a sign that the Fed had moved closer to setting an inflation target,
as many other central banks have done. The minutes of the Fed's
February meeting, published this week, confirmed that its policymakers
have discussed the idea. Advocates of targeting argue that it would
increase the transparency of America's monetary policy and maintain its
credibility after Alan Greenspan retires as Fed chairman in 11 months'
time. But at which measure of inflation should the Fed take aim?

It is widely agreed that central banks' prime goal should be price
stability. Judged by existing consumer-price indices, central banks
have indeed tamed inflation. But there are important things that such
indices ignore--homes and shares, for instance. And the prices of these
have been rising fast in many countries. Central banks should worry
about those as well.

When inflation targets were first introduced (in New Zealand in 1989),
the exact measure of inflation did not matter much. The main objective
then was to reduce high rates of inflation by anchoring expectations.
Today, however, consumer-price indices are arguably too narrow. Charles
Goodhart, a former member of the Bank of England's Monetary Policy
Committee, has long argued that central banks should instead track a
broader price index which includes the prices of assets, such as houses
and equities. America's core rate of consumer-price inflation
(excluding the volatile prices of energy and food) rose by 2.3% in the
year to January. But house prices rose by much more, 13%, in the year
to the third quarter of 2004 (the latest official figures available).
These are excluded from America's consumer-price index (CPI); instead
the cost of home ownership is represented by rents. But this can be
misleading: over the past year, rents have risen by just over 2%, a lot
less than house prices.

Ian Morris, an economist at HSBC, has devised a broader index, which
includes house prices, giving them a weight of 30%, the same now
attributed to the notional "rent" paid by homeowners in the core CPI.
In the year to the third quarter, inflation as measured by this broad
index was 4.9%, more than twice the rise in the core CPI. Assuming that
house-price inflation has continued at the same pace, THE ECONOMIST
calculates that broad inflation is now 5.5%, the highest since 1982
(see chart). Moreover, during the past three decades the gap between
the two measures of inflation has never been so wide for so long. 

If inflation in America is really higher than the official index
suggests, then interest rates should also be higher. Similar measures
would show inflation well above the standard figures in many other
countries too. The main exceptions are Japan and Germany, where house
prices have been falling. 

A LONG ECONOMIC PEDIGREE
The idea that central banks should track asset prices is hardly new. In
1911 Irving Fisher, an American economist, argued in a book, "The
Purchasing Power of Money", that policymakers should stabilise a broad
price index which included shares, bonds and property as well as goods
and services. Central banks already take account of asset prices by
estimating their effect on wealth and hence on demand and future
inflation, but the idea behind a broad price index goes much further,
acknowledging that asset-price inflation can be harmful in its own
right. 

The most obvious way is through a giddying rise and subsequent crash of
markets for shares or property. Big swings in asset prices can also
lead to a misallocation of resources and so slower economic growth,
just as high rates of general price inflation distort economies by
blurring relative price signals. For instance, soaring property prices
can encourage households to borrow too much and save too little, and
can pull excessive resources into property at the expense of other
forms of investment.

More fundamentally, if inflation is defined as "changes in the value of
money", then the consumer-price index is flawed because it only
measures the prices of current consumption of goods and services. A
classic paper written in 1973 by two American economists, Armen Alchian
and Benjamin Klein, argued that people care about changes in the prices
not only of the goods and services they consume today, but also of what
they use tomorrow. Because assets are claims on future goods and
services, their prices are proxies for the prices of future
consumption. If I buy a house--ie, a claim on future housing
services--and its price is higher than a year ago, then surely that
should be included in inflation since it reduces the purchasing power
of my money. Many consumer durables, such as cars, which also provide
services over several years, are already included in the CPI. 

If the prices of goods and services and those of assets move in step,
then excluding the latter does not matter. But if the two types of
inflation diverge, as now, a narrow price index could send central
bankers astray. Granted, asset prices are hard to measure: a rise in
house prices may partly reflect an increase in the average quality of
homes; and economists disagree over what weight house prices should
have in a broad index. Yet buying a home is an enormous expense, so it
is absurd to use such a rough approximation as rent, as does America's
CPI, or to exclude the costs of owner-occupier housing altogether, as
does the European Union's harmonised index of consumer prices. 

Given the elusiveness of a perfect price index, central banks should
keep using conventional, narrow inflation targets, but be prepared to
undershoot them temporarily if house or share prices soar. This means
taking a longer view than hitherto: an inflation target looking only
two years ahead is too short-term. And although the calculation would
be tricky, central banks might usefully publish broad price indices,
including asset prices, beside existing measures. They would then find
it easier to explain why they must sometimes raise interest rates when
conventional inflation is low.

See this article with graphics and related items at http://www.economist.com/research/articlesBySubject/displayStory.cfm?story_id=3690986&subjectID=348918&fsrc=nwl&emailauth=%2527%2528%2540%2526%253E%2525%255C0720U4%250A

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