Price level shocks and bottom up theories of inflation

I think the ‘price level shock’ fallacy is related to another fallacy that we can divine the causes and future of inflation by adding up individual price series.

The price/level/inflation shock categorizer like Ian McCafferty thinks to himself: ‘oil prices won’t keep going up and up.  This a one-off.  Inflation is caused by the sum of the individual sectoral inflation rates.  So when this one-off oil price change is done, the oil sector will be back to contributing zero to the inflation rate.  Since we are inflation targeters, we can ignore the oil price rise.’

But this is all wrong.  What’s happened is that there has been a change in lots of relative prices [brought about by a complex mix of demand and supply factors].

Notably, there has been a change in the price of oil as a final good relative to the other final goods;  and a change in the price of oil relative to other inputs;  and a change in the price of labour relative to what a given bundle of labour can produce.

When prices in the oil/petrol sector fall, we can’t simply project forwards the other sectoral inflation rates as before to work out what will happen.

What happens to these other sectors depends on what the central bank chooses to do with its policy instrument.  If it wanted, it could make sure that the sum of these sectoral inflation indices added up to zero.  Or whatever.  And what it was appropriate to do depends on a whole host of things, as I went through in the previous post.

This inflation is caused by the sum of its parts problem rears its head every time new inflation data gets released.  Where we can read that inflation was ’caused’ by the prices that went up, and inhibited by the prices that went down.  A classic example of this being this piece in the Guardian.  (Though this problem is ubiquitous).

Sometimes this is harmless semantics.  Often it can badly mislead.  Next time you read ‘inflation soars as clothing retailers jack up prices’ pause a moment to say a prayer that the writer has not fallen foul of the bottom-up theory of inflation fallacy.

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One Response to Price level shocks and bottom up theories of inflation

  1. eric says:

    A good example of why “economics” is a complex adaptive system, whose outcomes cannot be accurately predicted, as well as why policy intervention–be it monetary and/or fiscal–will never
    consistently have the intended results.

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