Abstract: In this article, the author talks about the necessity to adopt a broader definition and measure of inflation against the backdrop of a low interest rate environment worldwide and when traditional inflation measurement can hardly reflect the actual cost of living which hence has brought challenges to monetary policymaking. While inflation per se is one of the target variables, it is not necessarily a perfect reflection of residents’ well-being and economic performance, which implies that monetary policy has to take into account the economic reality beneath the inflation indicator. As many countries find themselves hard to achieve the inflation target, it would be wise to specify the appropriate targets and methods to measure them. A broader definition of inflation may be needed as the measure of inflation is a complicated issue to any economy and society therefore deserves further study.
The outbreak of the COVID-19, particularly the experiences and practices of major developed economies in recent years have shown that low inflation has not only become a challenge to monetary policy operation and theory, but also shaken the theoretical foundation of the inflation targeting mechanism. While this concerns many issues, the most important one is whether the monetary policy framework in major developed economies can adapt to the needs of the economic and financial situation at present. This is related to the theoretical and empirical dimensions of monetary policy including the validity of the Philips curve.
In a recent interview, Dr. Richard C. Koo said that inflation targeting barely works now and could even cause asset bubbles. His remarks have triggered heated discussions, particularly as to how central banks’ monetary policy should tackle the current economic and financial situations in the context of COVID-19 and low inflation rate.
One of the basic economic laws the textbook has taught us is that excessive monetary easing (with money supply growing at a faster pace than the growth of GDP) will lead to inflation. But this law appears to be disappearing in recent years, posing significant challenge to basic knowledge.
Logically, there might be three causes of the change in this law. First, the definition and scope of money might have changed. Second, the relation between money supply and inflation might have changed. Third, the definition, scope and measure of inflation might have changed.
As there have already been some discussions on the first two issues, I want to discuss the third issue to which little attention has been paid. Are there any problems with how inflation is defined and measured? If inflation is to remain at a low level for a long time as many anticipate, would that imply there are problems with the central banks’ approaches to addressing low inflation?
The measure of inflation has been constantly improving within the traditional framework, via dynamic adjustments to the basket of goods used for the calculation of the price index. Technically this is a scientific effort with hardly a reason to nitpick. But there is some doubt as to whether it is appropriate to assess the effectiveness of monetary policy using the inflation indicator.
The first issue I want to raise is whether the inflation rate determined under the current definition and measurement framework is the ultimate target variable that policymakers should monitor, or is it an intermediate variable? For monetary policy, does the indicator of inflation hold enough information or is it but one of many economic measures in hand?
To monitor the dynamic development of society and economy, we often utilize intermediate variables which, however, are not what we truly care about. However, over time, people will tend to believe that the intermediate variables are the target variables. For instance, M2 had been used by many central banks as a measure of the degree of monetary expansion for many years, but as the relationship between the two turned out to be unstable, it became necessary to revise the definition and scope of M2 or seek other measurement methods.
In the case of inflation, there also exist several indicators which are applied to analysis of different scenarios (e.g. the consumer price index, investment goods price indices and GDP deflator reflect the changes in the price of final goods, while the producer price index reflects the change in the price of intermediate goods).
An example from engineering can help explain. One of the traditional methods to measure temperature is using the mercury thermometer. Mercury swells or shrinks with changes in the temperature. Another method is using the bimetallic strip thermometer. The two types of metals have different swelling coefficients as the temperature changes. The measure of temperature is based on the change in shape as a result of the difference of the two coefficients. Unfortunately, in some circumstances e.g. metal-smelting which requires measuring high temperatures, these two methods no longer work because high temperatures can cause mercury to evaporate and soften metal.
As a result, another intermediate variable would be needed, for instance the color of an object which has some kind of mathematical relationship with the high temperature to be measured; or there is mapping between the two. If the mapping between the two is linear and stable, the intermediate variable can help measure the temperature. But an important factor is whether the relationship is stable or would change under certain circumstances.
Overall, inflation is both a target variable and an intermediate variable central banks use to observe financial and economic performances. The purpose of observing inflation could be improving the well-being of residents, ensuring the stable operation of the economic system and improving the public’s expectation on the stability of the economic system.
US President-elect Joe Biden flagged “cost of living” during his presidential campaign. While the concept is relatively ambiguous, it is close to the definition of inflation in the broad sense, and might be what people truly concern. In my opinion, it contains two meanings. First, the living standard that could be purchased with a certain level of income. This concerns not only the change in the price of a specific basket of goods, but also change in the goods included in the basket. Second, the cost of earning a certain amount of income. In other words, does it cause a lot of hardship and fatigue or is it relatively easy for people to earn the income? Such kind of comprehensive and ambiguous concepts influence people’s expectation on future life quality.
Inflation is one of the variables to be measured, but may not perfectly reflect residents’ well-being and economic operation. Monetary policy must consider people’s actual experience beneath the inflation indicators.
From the perspective of measurement, what do we really want to know from the inflation rate? The answer may involve the following considering the “cost of living” concept above.
First, what is the real income adjusted for inflation? How much has it increased? The real income is the difference between nominal income and inflation.
Second, what kind of living standard can be purchased with comparable levels of income? Are we now living a better life than before? One approach to this is comparing with the previous year. Generally speaking, the structure of spending rarely changes within a year, and it is easy to deduct inflation. Another approach is comparing with a period longer time ago. For instance, do we have a better life when compared with the last generation? The longer the interim period, the harder it would be to compare, because spending structure tends to change significantly over time, which concerns not only the spending on goods and services but also a broader range of things.
Third, the amount of work needed in exchange for the same level of income. Does it cause people more hardship and fatigue or less work is required than before? By thinking in this way, we can formulate the relationship between the amount of work and people’s utility. The “amount of work” here refers to how much effort a worker will have to make in order to achieve a certain amount of income with certain productivity and efficiency. Or it could simply be measured with working hours. In the meantime, how much utility does it bring to workers and households? People are indeed spending more than before, but if they work overtime every day, commuting is tough and time-consuming, and get few weekends off, it means they are working too much. Therefore, the ratio of work to utility should be what we care about, which we could observe through inflation indicators. But obviously there should be other indicators besides the inflation rate.
Generally speaking, while inflation is conceptually a target variable, it is also an intermediate variable in some cases and is not what we truly care about. Meanwhile, there are many variables that we should observe closely and inflation is just one of them.
The year-on-year measure of inflation is seemingly credible without being technically problematic. But when we think about it carefully, there are some challenges to this measurement method. The goods included the basket can change significantly when it comes to multi-year or cross-generation comparison. This will challenge the comparability of measurement, particularly for items which did not exist in the basket in the early years or disappeared later making benchmarking difficult. Such items include life expectancy (which concerns the provision of pension, healthcare etc), job skills, computer and internet, tourism and recreation among others. It is difficult to compare the changes in the prices of these items even with annually compounded inflation measures.
In addition, there has been much doubt as to whether traditional price indices can effectively reflect the cost of living considering the significant increase in world population and the degree of urbanization which have led to the shortage of urban land and sharp increase in housing prices. Traditional measure of inflation is facing the following challenges.
I. Failure to include asset prices can cause distortion, particularly in the case of long-cycle comparison.
Monthly and year-on-year inflation rates can fairly reflect short-term economic performance, which, however, could be problematic in practice. For instance, from a long-term perspective, one prominent problem in the measure of inflation is little inclusion of the prices of investments and assets, with the weights of these items being extremely low in the basket of goods. Under the traditional framework, the indicator that is closely related to consumers is the consumer price index (CPI). Compared with enterprises and entrepreneurs, consumers care less about investments The rise in the prices of assets seemingly has little to do with CPI, which in fact does affect the cost of living. For example, the rise in asset prices will undoubtedly reduce the return on pension investment.
In his article The Fed Is Really Running Out of Firepower, former New York Fed President William Dudley said “When interest rates stay low for long enough, the policy can even become counterproductive. In the U.S., monetary stimulus has already pushed bond and stock prices to such high levels that future returns will necessarily be lower. Assuming stable valuations, expected equity returns over the next decade are probably no greater than 5% or 6%. The 0.7% yield on the 10-year Treasury note doesn’t even cover expected inflation. As a result, people will have to save more to reach their objectives, be they a secure retirement or sending their kids to college. That leaves less money to spend. Even if people don’t save now, low returns will eventually take a toll. State and local pension funds, for example, will fall even shorter of what’s need to cover their obligations. To make up the difference, officials will either have to raise taxes or cut benefits for pensioners. Either action will leave people poorer, depressing consumer spending and economic growth.”
In the past, buying a house was deemed as making an investment, and changes of property prices were not included in the CPI. Later, rent was included, but its weight in the basket was very small. Then there was a voice to include residential house price, converted in rent expense, in the CPI, but the weight was still relatively small. When the global population rose to 7 billion, urbanization had become an inevitable choice for a large portion of population. Urban land became scarce and expensive, making house prices an essential element in the measurement of inflation.
In short, there are problems with long-term measurement of inflation, especially how asset prices should be reflected in measures of life quality and expenditure. That long-term investment returns should be discounted to include in the measure of current inflation also should be considered. In the United States, many white people in the central region are not happy with their lives and seek changes, which has caused significant changes in American politics and elections. One thing is that the white Americans in the central region do not feel they have a better life than the previous generation. There needs to be a comprehensive evaluation of their life quality by looking at long-term expenditures on houses, cars, education, medical care, and pensions.
In his article, Dudley also mentions families’ economic burden of providing for university education. Economically, for the previous generation it’s not difficult for American families to send their children to colleges. But now many people say it’s hard. For one thing, the standard is higher than before. For another, the cost of education is rather expensive today, especially private school and tutoring classes. From this perspective, people are not having a better life than their previous generation. Apparently, the current inflation measurement has not reflected these problems.
II. Define income used as the expenditure basket for measuring inflation
Currently, the CPI's expenditure basket is disposable household income. First, let’s have a rough definition of income: gross income of businesses and self-employed refers to sales revenue; net income before taxes and fees is gross income minus input cost, which corresponds to value-added in GDP; income of employed workers after paying income tax, social security contribution, medical insurance is defined as individual/household disposable income.
In reality, the living standard and quality of families and individuals to a large extent depends on non-disposable income, such as public services enjoyed by paying taxes, advance funded pensions, mandatory insurance, etc. We need to think about if the items corresponding to these non-disposable incomes become more expensive and whether they should be considered in measuring inflation. The proportion of these expenditures in total income cannot be ignored.
For example, advance funded pensions that are included in the public financing pool are likely to be paid from workers’ income through different channels. Some are paid by employers and some by employees. Usually this part of income is not counted in a household’s disposable income, but weighs heavily in people’s consumption and life quality. In the United States, total medical and health insurance expenditures account for 17-18% of GDP, which are funded partly by taxes, and partly by various compulsory, semi-compulsory or voluntary insurance contribution. The proportion of these expenditures is very high and cannot be underestimated, but a considerable part of it is not included in disposable income.
It should be noted that there lacks consensus among countries as to whether non-compulsory pension and health insurance programs (such as 401K in the United States) which most people participate in should be counted in a family's disposable income. In any case, “wool always comes from sheep”. When people believe that they need to pay more taxes, insurance premiums, etc. for pension, medical care, and children’s education, it means these items have become more expensive. In this regard, a more comprehensive price index based on net income before taxes and fees and corresponding inflation may better reflect the "cost of living".
From the perspective of monetary policy, in the past, price index changes were examined from the relationship between the supply and demand of money. Later, more attention was paid to the anchoring effect of inflation targeting on inflation expectations. There is the inflation expectations theory. When expectations are stabilized, inflation can stabilize. This expectation will also include estimates of the cost of housing, pensions, medical care, and children’s education in the future. With demographic changes, many young people have to take care of their children and parents, and thus won’t have much disposable income. They feel that their lives will be under much pressure in the future. However, this expectation is not reflected in the current inflation measurement.
The national economic statistics matrix shows that about 80% of the taxes and fees collected by the government benefit the public in the form of public services, including education, health care, pensions, security, municipal administration, and environmental protection. And a small part of the public services has not been felt and recognized by individuals and families. The quantity and quality of these public services that the public obtains directly or indirectly are related to price changes, which are conceptually inflationary or deflationary.
Some asked whether increasing government subsidies would improve people’s expectations. With rational expectation, consumers will predict that government deficits and accumulated debts will grow increasingly larger which includes local government deficits and hidden debts, and sooner or later they will bear the burden by paying more taxes or through inflation. Again, "wool always comes from sheep." This means that inflation expectations based on working hours or net income will be different from the inflation expectations based on disposable income, posing a problem for monetary policy.
Another related problem is whether people can accurately perceive or measure their net income before taxes and fees. Many unaccounted incomes are withheld or paid by companies, and some are not transparent. By knowing one’s net income well one can better perceive inflation and have expectations. Generally speaking, it is not easy for people to know what their net income is, but the situation varies in different industries. The production and distribution process in some industries is relatively simple. For example, for taxi drivers, they have clear knowledge of their gross income, as well as costs such as car depreciation, gasoline, and maintenances. It’s easy for them to calculate their net income. After paying taxes, pensions, medical insurance, they can get to know their disposable income.
Family farms in the United States are similar. Knowing their earnings from harvest, and after deducting costs of seeds, fertilizers, and agricultural machinery depreciation, it is easy to calculate their net income. People can easily see how much of the net income is used for pension plans, health insurance, personal income tax and other expenses. The benefits of these expenditures are also perceivable. For example, with taxes governments can provide education (public schools), but some costs of education are not covered by the governments, such as extracurricular tutoring.
However, in some complex production processes, it is really difficult to know how much one should be paid according to his/her work. Although it is not easy to make the calculation, people often make horizontal comparisons, that is, on average, what the possible income level is if you do other jobs compared with people with the same education level, skill level, and work intensity.
In short, how to measure income and what income should be used to measure the basket of goods and services and calculate the price level will affect people’s perception and expectation of inflation. While the basket of household disposable income becomes smaller, the price of goods and services outside the basket rises. According to macroeconomic models, it is clear that the average net income of workers of different groups is equal to marginal contribution of labor to GDP.
III. How do working hours affect people’s perception of inflation?
As mentioned earlier, one of the indicators that people want to measure is how much one has to work to earn certain income, or in other words, the working hours needed to obtain a specific level of consumption utility. In economics, utility in the narrow sense refers to the satisfaction from consumption. In a broad sense, it refers to consumption satisfaction derived from a certain amount of labor, and in a broader sense, it also includes the type of satisfaction from less work and more leisure. It should be noted that there is no convincing and precise definition of "utility". It has been shown that "utility" cannot be measured quantitatively and can only be ranked. But the concept of labor/utility (ratio) is obviously related to inflation.
Some have said that his/her annual income can barely afford a bathroom of 5 square meters. Then, is there inflation if the same bathroom will cost him/her two years’ income after several years? The calculation is based on the assumption that his job skill. work load as well as efficiency remain the same over the two periods. Inflation’s effect on people’s life could be understood from the broad price level and people’s income. If the same level of utility can only be attained with more work, it means inflation is happening.
Another type of expenditure is people’s spending on education, training and learning, which to some extent are intended to improve their competitiveness in the labor market. As competition intensifies and automation, robot technology and AI continue to advance, people have to invest in education to remain competitive. This has increased employment-related input, pushing up the proportion of investment in their expenditure.
Some economic literature have discussed the concept of “l(fā)eisure” and its function. That people need to take vacations or “go back to the garden of Eden” indicate the fact that leisure can create utility for people that working hard, making money and consumption cannot bring. However, leisure and its utility can hardly be measured with the price index or the concept of inflation in modern economics. When people travel, related expenses such as transportation and accommodation can be measured and are subject to the influence of inflation. On the other hand, if people stay at home enjoying time alone or with families, listening to music (not newly purchased) or reading books (borrowed from libraries), they can also have a strong sense of satisfaction. However, it is hard to measure these activities with prices or included them in the utility function. They are not subject to the influence of inflation, and cannot drive GDP growth either.
It’s uncertain whether we could come up with an innovative economic model to solve the problem. However, one thing that we are almost certain of is that around some equilibrium point, when one spends more time on leisure, he will spend less time on work, and vice versa. If people spend more time on working and commuting, and the retirement age keeps rising, they will have less time for leisure. It sounds like doing more work in exchange for less utility, and this is similar to a type of inflation. The current inflation statistics and analysis have not taken the above-described concept and relationship into account yet, but they could offer a clue as to what exactly we want to measure, the reasons behind the lack of satisfaction with life observed in certain groups of people, and the implications for monetary policy.
IV. Benchmark, comparability and the frame of reference
Generally speaking, each component of the price index has it weight, which is measurable and adjustable. That makes cross-year comparisons possible, and a comparison across multiple years would be the integral (accumulation) of the comparisons between each two adjacent years. However, scientific in mathematical terms as it is, sometimes the results this method produces are not consistent with people’s perception and expectation of inflation.
When the consumption structure goes through significant adjustment, the benchmarking and weight allocation methods would be challenged; as technologies quickly advance, prices of IT products go down quickly which could result in overestimation of deflation; moreover, compared with the above-mentioned cross-year comparison, many consumers prefer to do horizontal comparison, which could result in different conclusions. It would be wrong to say that consumers are unscientific in their method, because even though the cross-year comparison formula is correct, it is the consumers’ inflation expectation and behavior that we need to study. The reason why we measure inflation and prices is to make comparisons, and that’s why comparability is relevant here. However, this is not only a matter of comparability and whether related concepts and methods are scientific, but more importantly, we need to consider which comparison method is preferred by the majority of consumers, because it’s their choice of approaches that determine their perception and expectation of inflation.
Then what is the choice of the majority of people? Take the purchase of computers for example. The running speed of the CPU, memory size and cloud storage space of computers improve every year, and if we take Moore’s law into consideration, in terms of the computers’ value for money, consumers should feel their living standards greatly elevated each year. And if they look at it over a time span of five, ten years or even decades, they should be able to see even bigger improvements and negative inflation. However, many consumers actually compare horizontally by looking at the performance of the computers that other people around them are using, and if their computers are outperformed, they would have the feeling that others are living better lives than themselves. They don’t only compare vertically.
The same is true with many other things, such as the lifespan. Two decades ago, the average lifespan of the Chinese people was 71 years or so; now the figure is somewhere between 77 and 78, and soon it will reach 80. Then, are those who live for 7 decades or longer feel satisfied with their lifespan? They live much longer than the last generation after all. However, truth is, nowadays most people live above this age, and some would even consider it an early death if someone passes away at 70. The situation is totally different from decades ago. This shows the way in which people from perception and expectation does not strictly follow vertical comparison formulas or statistical concepts.
Closely associated with lifespan is pension and inflation. The past generation with an average lifespan of 70 years generally retired at the age of 60, which means that they work for several decades to accumulate pensions, be it government-funded, saved in their personal account or annuities and life insurances, to support their expenditures in the rest 10 years of their life; but now, they need to plan for almost two decades of their later years. Even if the retirement age is elevated to relieve the situation, working groups will have to spend more on their old-age care. Although part of these expenditures does not fall into the category of disposable personal income, on average, it’s still earned by the people themselves with hard work. Then asset prices matter. If stocks are expensive and the bonds have low yields, even if people invest for decades for their old age, the eventual amount of pension they get will still be insufficient.
Conversely, if people have to set aside a larger proportion of their net income for pension to achieve a level of old-age life comparable to their previous generation’s, it’s equivalent to a price hike. Besides, most of medical expenditures are usually incurred during the late years of one’s lifetime, so people generally save for them over a long period of time; as a result, the returns on such savings are also closely related to asset prices.
In education, similarly, people usually compare with their peers when forming expectations of job opportunities and their prospects. They would not compare with previous generations. They would spend more years and money on education, and no matter it’s the government or themselves who pay their education bills, they will have the feeling of inflation happening.
The fluctuations in asset prices are very unpredictable. The recent wave of asset price changes is especially clouded with uncertainties, which to a large extent is related with Big Techs. Back in 2001 and 2002, the NASDAQ experienced a burst of bubble; and people hold different views as to whether now there are bubbles building up. If asset prices remain high amid a bubble, investments would be very expensive; yet, regardless of that, people will definitely spend a proportion of their net income, whether within the scope of dispensable income or not, on investments as an indispensable component of their expenditure in the current or later periods, and in conceptual terms, this is related to inflation in the broad sense and also to income distribution.
Simply put, in the past, the price of investment goods and assets could be considered separately, but I’m afraid we can’t continue with this now. Looking ahead, pensions and medical expenditures will be in huge amounts. And the funding of these expenditures relies on investment returns over the long run. Asset prices influence not only the expansion of businesses, but also public spending such as infrastructures and environmental protection. It’s imperative that we factor asset prices into the measurement of inflation.
Several challenges exist for inflation and its measurement. Current measurement of inflation, which used to seem very mature, is far from ideal when we look at it now – obviously, the price of investment goods and assets has been overlooked. Failure to achieve the inflation target with monetary policy is a common challenge facing many countries now, whether headline inflation or nominal inflation is used. Recently, the Fed turned to focus their endeavors on realizing the average inflation target. If the inflation rate calculated with past method stands low while there is a remarkable rise in asset prices, we can no longer neglect the methodological deficiencies, and monetary policymakers can no longer ignore it.
To sum up, we need to redefine the inflation target and how to measure it. Measurement could be very complicated in the current economic and social background, and we may need a broader concept of inflation; as to how to measure it, further in-depth research will have to be conducted.
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