Well or badly measured, falling Eurozone inflation is bad news.

John Kay reminds us in his latest FT column that inflation is a statistical chimera. From time to time, new things are invented or desired, and old things no longer bought, and all the time what we buy gets improved. These and other problems, Kay’s piece argues, complicate comparing prices over time and so we should not obsess too much about the latest numbers for Eurozone inflation.

However, contrary to Kay’s line of thinking, in my view our angst about these published data should not be diminished by recognizing these imperfections.

The first point to make is that these biases are a big deal, and so far research suggests that they weigh decisively in one direction, something one may not appreciate from Kay’s line that ‘there are probably more upward than downward biases’.  One finds estimates of 1-2.5 percentage points on annual inflation, (See, for example, the original and famous Boskin Commission ReportHausman’s Journal of Economic Perspectives survey, Robert Gordon, and Mark Wynne specifically on the Eurozone’s HICP).  So 0.3% measured inflation means something like -0.7% to -2.2%.

Paul Krugman has made interesting points about the fact that one should not take comfort from the fact that prices are not actually falling, since ‘lowflation’, inflation lower than expected when nominal debt and wage contracts were signed, is damaging in the same way.  But, recognising that published figures may greatly overstate inflation, these debates are somewhat academic, since we may have left ‘lowflation’ behind some time ago and already crossed the Rubicon of deflation by some margin.

Second, although we don’t know precisely what inflation is, and suspect it is a great deal lower than 0.3 per cent, we do know that it is 1.7 percentage points below the 2% target, a rate that was designed to accommodate reasonable estimates of biases in CPI with the intention of avoiding deflation in true, unobserved prices.  This gap between actual and target, [just like the falling measured inflation], is cause for concern, regardless of the data’s mismeasurement.

Third:  these biases, though large, can probably be taken to be relatively constant from year to year.  So, although the published numbers give a poor read on true inflation, changes in inflation are much more faithfully recorded.  The slow but persistent slide in inflation, despite the ECB’s tardy but substantial measures to loosen conventional and unconventional policy instruments, is rightly taken as suggesting that policymakers have not yet done enough, and that a risk of entering a full-blown Japan-style liquidity trap, with interest rates forever trapped at the zero bound, is considerable.

Fourth, if either these biases are unchanging, or private forecasters take falls in Eurozone CPI to capture faithfully what is going on, (or both), the fall in inflation we watch may lead people to forecast lower true inflation in the future, in which case they will record and experience a rise in the real interest rate.  That is like a policy tightening, raising the cost of borrowing, depressing spending, encouraging saving, and driving true inflation down further, absent some further policy loosening.

Although the Eurozone HICP is not a great device for measuring the power to purchase pleasure over very long periods, like the gap between Nathan Rothschild’s final illness and today, the problems with it are well-known, and relatively unchanging.  Greatly below target and falling measured inflation gives a very good picture of the failings of current policy, and should be cause for much concern.



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