People Are Confused About Inflation Because Economists Are Working With a Confused Idea

A blog about business and economics.
Nov. 20 2012 3:39 PM

People Are Confused About Inflation Because Economists Are Working With a Confused Idea

There's tons of public confusion out there about inflation all the time, but rather than worrying about why the public is so confused about it I think we should worry first and foremost about why economists are working with such a confusing concept.

Here's a slice of Ben Bernanke's speech at the Economic Club of New York today where he talks about inflation:

As is often the case, inflation has been pushed up and down in recent years by fluctuations in the price of crude oil and other globally traded commodities, including the increase in farm prices brought on by this summer's drought. But with longer-term inflation expectations remaining stable, the ebbs and flows in commodity prices have had only transitory effects on inflation. Indeed, since the recovery began about three years ago, consumer price inflation, as measured by the personal consumption expenditures (PCE) price index, has averaged almost exactly 2 percent, which is the FOMC's longer-run objective for inflation. Because ongoing slack in labor and product markets should continue to restrain wage and price increases, and with the public's inflation expectations continuing to be well anchored, inflation over the next few years is likely to remain close to or a little below the Committee's objective.

Why is a central banker talking about the weather?

Well because he's decided that monetary policy should be largely about inflation. And by "inflation" he means the personal consumption expenditures price index. Which is to say he's worried about the cost of living. But the cost of living is a question of supply shocks (drought) and the real purchasing power of wages. Exactly the things monetary policy can't control. So you get a lot of hemming and hawing about whether inflation expectations are "well anchored" and stuff about core inflation and discussions of droughts in monetary policy speeches. And they teach this stuff to kids too. Both the European Central Bank and the San Francisco Fed have monetary policy games on their websites that tell you respond to bad weather with tight money.

The logic is easy enough to understand. Tight money curbs inflation and inflation is high prices and bad weather causes high prices, so clearly we need to fight bad weather with tight money.

In the real world, that makes no sense. Monetary policy is about nominal problems. Bad weather is a paradigmatic real problem. "High prices" is an ordinary language word that's ambiguous between a nominal issue and a real issue. But "inflation" is supposed to be an economist's term of art. Yet instead of using it like a term of art—something with a precise meaning that distinguishes between real and nominal issues—it's used as a synonym for "higher prices." But this invites confusion. High compared to what? Common sense says compared to your ability to afford them. Seventy years ago cars were expensive luxury goods and today nobody can afford to pay a doctor to make a house call. This is a mangling of the concept of inflation, but no more so than talking about the weather in a monetary policy speech.

The thing that people dislike is when nominal consumer prices rise faster than nominal incomes. It's not difficult to understand why people dislike that, and it's exactly the kind of thing that bad weather does cause. But if central bankers want the public to understand what they're doing, they have to take more care in their own dialogue to distinguish between nominal issues and real scarcity.



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