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Pumped up

One of the main complaints I hear is about ‘inflation’. However, the system we have in place for dealing with inflation in this country is a good one—which could be more obvious if we created a real inflation measurement. We do have a consumer price index, and people generally accept the idea that growth in the consumer price index is inflation. But an economist’s definition of inflation is very different.

When we see the price of something increase, there could be two reasons. First, the relative price of the good may have risen, implying that this good is scarcer relative to supply and demand. This type of price change is required, even if it means an unpleasantly sharp increase in fuel prices. Second, there may be persistent pressure on the price of all goods and services to increase and this is what economists call inflation. The central bank can control this second type of pricing pressure, but is severely limited when the economy is faced with a change in relative prices.

When we look at the CPI, both types of price changes are captured—so if some goods and services are subject to shocks that are pushing up their price, growth in the CPI will overstate inflationary pressure.

When people complain about inflation, they are usually complaining about a sharp increase in petrol prices due to scarcity, an issue that policymakers can do little to improve.

If we produced a real inflation index and had the central bank concentrate on keeping growth in this index at a level consistent with price stability, it would be easier for the public to understand what the bank can achieve and how it will respond.

The primary driver of real inflation is expectations. Households and businesses’ expectations of growth in the general price level determine pricing behaviour, which in turn determines what growth in the general price level will be: a self-fulfilling cycle. By clarifying the difference between the two types of price growth there will be less pressure on the central bank to do things it can’t—such as helping to increase incomes following a sharp lift in petrol prices.

Matt Nolan is an economist at infometrics and blogs at www.tvhe.co.nz