Recent Items

Inflation conundrum

Posted on by

Krugman doesn’t think inflation expectations will lead to wage growth:

… inflation is well under control: wages aren’t taking off, the labor market is weak, and once oil and food price spikes end we’ll be, if anything, in a deflationary environment… I don’t think there’s any fundamental inflation problem, just a one-time hit on food and energy.

and posts the following chart on correlations to show that it really is different this time:

20080806_Inflation_Wages.jpg

Menzie Chin on EconBrowser has a very interesting chart which may explain why it doesn’t feel as if inflation is contained, and asks “Is the GDP deflator plausible?”

20080806_Purchase_Inflation.jpg

Four quarter inflation rate for GDP deflator (blue) and gross domestic purchases (red), calculated as 4 quarter log difference. NBER-defined recession dates shaded gray. Source: BEA GDP release of 31 July 2008, and author’s calclulations. Figure 1 highlights how the inflation rate for what we buy has accelerated over rates for what we make.

The way I read this is that the purchase deflator is consistently running ahead of the production deflator, except for a brief period in the 2001/2 slump, and since mid-07 they have completely diverged. The other term for a price change which deflates what you export/sell and inflates what you import/buy is a terms of trade shock. I suspect that the US middle class is experiencing just that on a personal level.

UPDATE:

James Hamilton at EconBrowser further explains the difference between “inflation” – which only describes what is produced locally – and let’s call it “purchasing power” – which includes the imported things I also buy – in a way that even I can understand it, ie. with coconuts and oil.

In 2007, Islandia produced 500 coconuts, which residents sold to themselves for $1 each, and imported 1 barrel of oil, which cost $100… Nominal GDP in Islandia for 2007 was $500. If you wanted to describe that in real terms, you’d call it 500 coconuts. You don’t count the oil in either nominal or real GDP because Islandia didn’t produce any oil… 

Here are the numbers for 2008. We grew 510 coconuts, sold them for $1.01 each, and still imported 1 barrel of oil, paying $125 for it. So nominal GDP was $515.10 (a 3% increase) and real GDP was 510 coconuts (a 2% increase). The change in the implicit GDP deflator would be the change in the ratio of nominal GDP to real GDP, namely, +1%… 

But wait a minute, Islandia’s pundits decry. How can your crummy accounting claim that inflation was only 1%? Last year we bought 500 coconuts and 1 barrel of oil for $600, but this year if we tried to buy the same thing it would cost us $630. The inflation rate, they tell you, is obviously 5%, not 1%.

Now I understand. But since I buy at least some imports every year my purchasing power is not even meant to be described by the “inflation” number. So TIPS aren’t really going to do me any good are they. What I need is a “purchasing power” protected bond. Likewise, if I want to know if my wealth is growing in “real” terms it does me no good to compare it to inflation – a production basket which only includes part of what I need to buy.

I am genuinely surprised after all this time to discover that inflation was never intended to do this.

Print Friendly
Twitter0DiggReddit0StumbleUpon0Facebook0LinkedIn0Google+0bufferEmail

17 comments

  1. lv

    Paul,

    With all due respect, it appears that you do not understand what James Hamilton said. The whole point of James Hamilton post was that the GDP deflator (the thing that you call “inflation”) is really not a measure of inflation as we intuitively understand it because it only includes price changes of goods and services that enter the GDP calculation. That is the reason why when we talk about inflation other measures, such as the CPI (that indexes TIPS, if I am not mistaken), PCE deflator, etc. are used. To make a distinction between “inflation” and “purchasing power” in this context is completely innappropriate.

  2. Anonymous

    I agree with the previous comment. This was a good post for clarifying the difference between the GDP deflator and the CPI.

  3. wintermute

    The example is an incomplete “closed system” because it does not take account of exports – which presumably are needed to pay for the oil. In the 2nd year if 125 conconuts went offshore to pay the the barrel of oil then only 385 were available for domestic demand, down from 400 previously. Should real GDP exclude exports which are needed to offset imports?
    Or does Islandia have a world reserve fiat currency?

  4. a

    The first two commenters are right.

    More generaly, there is a tendency for many to eschew standard national accounts definitions of things like investment, savings, or in this case, GDP deflator, simply because a particular defintion doesn’t suit their purpose.. Some time ago, the blogosphere was ablaze with a debate about the definition of savings, for example. The standard rant amounted to the notion that savings should be marked to market to include capital appreciation on such things as stocks and houses. This ignored the fact that there is a very good reason for defining it the way it is defined, which is that it tracks the mapping of savings from current income into investment as a component of current output. In other words, it provides information value on the demarcation line between new and old as far as the difference between GDP and wealth is concerned. Moreover, the marked to market aspect is captured quite fully in the separate accounting mechanisms of the Federal Reserve flow of funds accounts.

    The above commenters have explained the case of the deflator quite well. People like to redefine things when they can’t get what they want from them, rather than making the effort to extract a consistent picture for the full range of available information sources.

    And to drive the point home further in this case, TIPS uses CPI, not the GDP deflator.

  5. Anonymous

    As ‘a” says, economics is a jig saw puzzle. People get frustrated when the piece they’re holding doesn’t do what they want it to. But another one usually does. And the one they’re mad at has a different purpose.

  6. David

    Well, from the street level, I’ll interpret. Krugman’s analysis is partly real politics and probably correct.

    We, “workers”, know that oil and housing and medical costs are going up in relation to our income even if we don’t purchase them…but wages are stagnant or going down. All of the above are way over valued but will not go down to a necessary level (like minus 40 percent to match their true worth). Now that food follows energy prices and that protected professions such as law, medicine, bankers, real estate, telecommunications, “the state” will continue to take their ‘cut’ in our production, our declining wages are forcing the average person to purchase less and less. Employers complain about greater overhead and ‘workers’ get less hours of work, more layoffs, etc. As a result there isn’t push-back for greater wages to offset the greater costs of living. So people just will have to tighten their belts. Result: Deflation.

  7. Anonymous

    so the CPI includes import price inflation, while the GDP deflator excludes it?

    in other words, oil import prices could double, increasing the CPI, but only have a muted impact on the GDP deflator?

  8. Jake

    A better example for James would have been coconuts and a fertilizer that is essential to grow coconuts. In this case had fertilizer doubled in price, I have feeling that $515.10 worth of coconuts would not have gotten you the 510 initially assumed by the Island’s BEA in the first round of its Real GDP calculation, but rather only 470 as the higher price of fertilizer increased the price of the final good, hurting demand. Thus, rather than an increase in GDP from 500 to 510 coconuts, there was a recession to 470 (same nominal GDP in both cases).

    At the end of the day, we need to look at the numbers and ask ourselves if they make sense and 1.1% does not. Should the GDP Deflator be as high as that implied by the CPI? Probably not, but somewhere in between would cause another revision to GDP, which was my point all along…

    For more info, please go here:
    http://econompicdata.blogspot.com/2008/08/beas-gdp-deflator-cut-bls.html

  9. Jim Driscoll

    Yes, the GDP deflator includes only local inputs, of which housing is a major component. If housing is going down by 20%, then that’s going to weigh the other bits down.

    Scandalously, the CPI includes external inputs (mostly in “non-core”: food and energy), but doesn’t include housing at all, instead using a freakish Owner’s Equivalent Rent calculation that missed the biggest asset inflation in US history, while giving happy numbers. The OER will continue to blow sunshine in the biggest asset deflation in US history as well. So it isn’t as though the CPI is a very good indicator either.

  10. Mara

    Actually I think this is an excellent argument to watch your own coconuts and not listen to the economists (or perhaps pelt them with coconuts).

  11. Jonathan Bernstein

    The impicit price deflator measures price changes in goods produced withing the country. The CPI measures price changes on a market basket of 400 goods that are weighted so as to replicate the expenditures of “average” or more precisely, “representative” consumers.

    Unfortunately, as John Williams shows at shadowstats.com, the Department of Labor over the years has made all sorts of adjustments to CPI calculations that make inflation seem tamer than it would appear to be under the old methods. The so called hedonic adjustments are the most notorious example of this.

    The CPI is, (or should be) the gauge used to measure the effect of price changes on consumers’ cost of living. However, it no longer does. Williams at Shadowstats does a good job of showing what inflation trends look like with consistent, apples-to-apples comparisons.

  12. Eric Prentis

    James Hamilton makes a very good point but misses the payoff. The GDP Deflator has a material impact on the Commerce Department’s announcement on 7/31/08 that the US economy grew by + 1.9% in the second quarter. The GDP Deflator number used was – 1.1%, consequently, the Nominal Second Quarter GDP was 1.9% + 1.1%, or 3.0%. If the CPI of 4.2% had been used instead, which is a much better gauge of consumer inflation, the second quarter GDP headline number for the economy would be a negative – 1.2 %. Politics is being played with government numbers, aided and abetted by economic professionals, so they do not scare the masses.

  13. Paul

    Thanks for the comments. I had certainly been naively conflating “inflation” with both CPI and GDP (and probably the value of a dollar).

    As I now understand it, a country can have “real” growth in GDP even while the value of that production in terms of global goods and services is simultaneously decreasing. They are making more and more of things that are simply worth less and less on the world market. This is interesting.

    Likewise, a country could have negative, or low, GDP growth while in fact gaining in terms of the global real purchasing power of their production.

    Something I need to think some more about.

  14. Anonymous

    ok, now that i'm thoroughly confused, what exactly constitiutes the PCE deflator?

    what are the differences between the PCE & GDP deflators?

  15. David

    Jim, housing is most family’s or individual’s most expensive item. During the 80s, (the Reagan era), it’s influence on the CPI was greatly reduced supposedly due to some reason along the lines of “local variations were too hard to calculate”. Supposedly, rent is still in there somewhere. Perhaps an investigation should be made into the political/economic ramifications of this noteworthy ‘deflation’ of most people’s ‘cost of living’(?).

    Juan, we’re on the same page. Real experiences should be analyzed. Academics and analysts need ‘real world’ inputs…not ‘deflated ones’. The widely esteemed and reviled Krugman has at least owned up to some past mistakes and tries to incorporate some anecdotal evidence of what ‘real’ people are going through. In that respect, he is esteemed by me but I don’t always agree. That’s to be expected. Oh, well. I come here to be elucidated. \

    Wow, Paul that’s what I was thinking in regards why do most people feel they are in a recession but the growth in GDP don’t show it. Could it be due to the overwhelmingly ‘service’ nature of our economy where ‘services’ are what the vast majority of ‘product’. I focus a lot on the “professional service” class but also wonder about the alleged growth in the financial sector. Curmudgeonly Kevin Phillips is all in a stir about the Finance sector being something like 20+ percent of the whole Pie (of USA’s GDP). That’s hard to believe and jaw dropping. I know it’s probably much of the reader’s jobs here…but what is the financial sector producing to gain that much of the pie? I know not if that figure is true and/or what it means…but I have suspicions.

Comments are closed.