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So what's the idea here? That oligopolistic/regulated prices have inertia and free competition prices don't, and the "real inflation" is in the free competition prices? This is nonsense for a variety of reasons.

First of all, the more capital-intensive an industry is the more it tends to oligopolistic/regulated prices. So, if you're going to exclude them from the price index because they exhibit inertia even if they have a large impact in consumers' shopping baskets or in economic flows generally, you're measuring something useless.

Second of all, I have recently developed this intuition that the more volatile prices and volumes are, the more inflation there is [for the physicists: I'm thinking this is related to the fluctuation-dissipation theorem - if I understood the latter I'd be able to tell you for sure]. So, if an industry sector displays price inertia, it should also display lower inflation than average. And so, by excluding it from the analysis, you get a high inflation estimate.

So, what are we doing? We're excluding the capital-intensive sectors of the economy from the price index, and we're introducing an upwards bias in the inflation estimate. Coincidentally, Krugman just wrote:

And all of this has a real, damaging effect on policy. The econ team at Goldman Sachs (not online) makes the interesting point that FOMC inflation forecasts are pulled up by a small group that keeps forecasting much higher inflation than anyone else; this in turn helps limit the Fed's willingness to support the economy. And the deficit hawks have, of course, killed any hope of more stimulus.
FOMC is the Federal Open Market Committee at the Fed.

By laying out pros and cons we risk inducing people to join the debate, and losing control of a process that only we fully understand. - Alan Greenspan
by Migeru (migeru at eurotrib dot com) on Sun May 23rd, 2010 at 02:55:01 AM EST
So what's the idea here? That oligopolistic/regulated prices have inertia and free competition prices don't, and the "real inflation" is in the free competition prices?

No, the real inflation is whatever the inflation is.

The point is that fixed prices tell you something about what the price-fixers think the future inflation will be. And prices being what they are, that can become a self-fulfilling prophecy.

Pure flexible prices, OTOH, don't price in expectations. So if you want a handle on what people believe the future inflation will be, you will have to compare the inflation in the fixprice and flexprice sectors of the economy. In other words, "core inflation" is pretty uninteresting on its own - the interesting figures are total inflation and the difference between inflation in fixprice and flexprice sectors, because it is that difference which tells you whether the fixprice sector expects higher or lower inflation in the future.

Second of all, I have recently developed this intuition that the more volatile prices and volumes are, the more inflation there is

That's an interesting intuition, and it may very well be correct. In that case, figuring out the relevant expectations would get a bit more complicated...

So, what are we doing? We're excluding the capital-intensive sectors of the economy from the price index, and we're introducing an upwards bias in the inflation estimate.

Actually, no. "Core" inflation is an attempt to exclude the flexprice sector, giving a downward bias.

And the more likely explanation for the FOMC having a problem with the whole "making accurate predictions" thing is that they assume long-run money neutrality. Forecasters who actually have to make more-or-less reliable forecasts can't afford rigid adherence to such ideological drivel, and will have to (tacitly) cast it by the wayside... (That's the kind version. The unkind version is that the FOMC is a group of hacks who fit the analysis to a pre-ordained conclusion.)

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sun May 23rd, 2010 at 07:06:45 AM EST
[ Parent ]
JakeS:
the real inflation is whatever the inflation is
That begs the question of that "inflation" is. And most definitions of inflation are circular or "fudge-factor" definitions, where all we have is a disparate collection of price and volume series and it's by no means clear that there is an index that captures it.

By laying out pros and cons we risk inducing people to join the debate, and losing control of a process that only we fully understand. - Alan Greenspan
by Migeru (migeru at eurotrib dot com) on Tue May 25th, 2010 at 04:16:41 AM EST
[ Parent ]
Yes, discounting - of which inflation is a sub-field - is inherently political.

But my point is that "core inflation" isn't an attempt to arrive at a meaningful discount rate: It is an attempt to divine the expected discount rate of fixprice market participants.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue May 25th, 2010 at 06:39:03 AM EST
[ Parent ]

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