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February 28, 2005

Which Inflation Rate?

Which Inflation Rate?

The Economist believes that when asset prices go up, wages should go down:

Economist.com | Economics focus: "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?...

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....

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....

The idea that central banks should track asset prices is hardly new. In 1911 Irving Fisher... argued... that policymakers should stabilise a broad price index which included shares, bonds and property as well as goods and services.... [A]sset-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....

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....

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....

I'm skeptical. Yes, I see danger in asset price bubbles. But I see more danger in monetary policies that force nominal wages to fall. Telling workers that you are cutting their nominal wages is as easy way to destroy worker morale. If firms refuse to do so--keep nominal wages fixed while the nominal money stock falls--you are asking for big macroeconomic trouble.

Posted by DeLong at February 28, 2005 03:56 PM