Wednesday, February 9, 2011

"Inflation confusion"

From the Federal Reserve Bank of Atlanta's Macroblog:

As opinion about rising food prices and the consequences thereof divides between "the Fed did it" and "the fundamentals did it" camps, I am reminded of the tricky nature of the semantics of any discussion about "inflation."
In case you need convincing of that yourself, take a look at the results of the most recent Pew News IQ Quiz. Of 13 multiple-choice questions on the quiz, the question that received the fewest correct answers was whether the national inflation rate reported by the government (as of November 2010, when the poll was taken) was closer to 1 percent, 5 percent, 10 percent, or 20 percent. Only 14 percent of the 1001 adults surveyed knew that the answer was 1 percent; more people knew David Cameron is the prime minister of the United Kingdom.
That response does not indicate a general lack of knowledge about economic issues.
Seventy-seven percent of respondents knew the deficit is larger now than in 1990s, 64 percent know that the United States runs a trade deficit, and 53 percent are aware that the current unemployment rate is closer to 10 percent than 5 percent or 15 percent. What I think the failure to identify the reported inflation rate probably represents is slippage between the definition of inflation that the average person has in mind and the definition that economists and central bankers are so intently focused upon.
That distinction was the topic of a speech given by Atlanta Fed president Dennis Lockhart earlier today, in which he said:
"In the most recent FOMC statement, following the January meeting, the committee acknowledged the rise of commodity prices, but stated that ‘measures of underlying inflation have been trending downward.'
"Yet inflation anxiety is rising. There seems to be a disconnect between what the Fed is saying and what people are experiencing when they fill up their gas tanks or read about rising food prices around the world.… Are the Fed and the public on different planets?
"Certainly not. But I do think in the swirl of official statements and public discourse we may be talking about different things. To my way of thinking, the term ‘inflation' is misused in describing rising prices in narrow expenditure categories (for example, food inflation). Nonetheless, recent price news has encroached on the public consciousness with the effect that any price rise of an important consumption item is often taken as signaling inflation."
The key distinction is the one between the ideas of "the purchasing power of money" and "the cost of living." Again, quoting President Lockhart:
"Let's review what inflation is and is not. Inflation affects all prices. Inflation is not the rise of individual prices or the rise of categories of prices.

"I want to contrast inflation to the cost of living. In casual language, we often interpret a rise in the cost of living as inflation. They are not the same thing. Cost-of-living increases are a result of increases in individual prices relative to other prices and especially relative to income. These relative price movements reflect supply and demand conditions and idiosyncratic influences in the various markets for goods and services. If some component of a household's cost-of-living basket goes up in price, the higher cost of living is not ipso facto inflation."
When food prices rise or oil prices rise, people are right to feel in some sense worse off, because they are....MORE
FT Alphaville comes at it from another angle:
The inflation disconnect, charted

Atlanta Fed President Dennis Lockhart was talking about discrepancies between Americans’ view of inflation and that of the US central bank in his Tuesday ‘disconnect’ speech. But you can see that disconnect most clearly in the discrepancy between market interest rate expectations and the Fed’s actual rates.
Here’s a recent chart from Bank of America Merrill Lynch:

That’s the forward curve for the Fed funds rate plotted at of the end of each quarter against the actual (effective) rate....