Inflation Measurement and Monetary Policy

David Lebow

Federal Reserve Board

May 13, 2008

Central banks use inflation for different purposes

• Internal analysis and forecasting– No single measure best– Core inflation useful

• Public communication– Clarity and simplicity are virtues

• So stick to one price measure

– Overall inflation important

Under-studied topic: Scope

• What price measure should a central bank most want to stabilize? Must it be a consumer price?

• Depends on perceived cost of inflation– New Keynesian literature: relative price

variability affects resource allocation– Fischer-Modigliani (25 direct effects plus 25

indirect effects)– Money illusion and long-term planning

• On whom do the largest costs fall?

• Possible scopes– HH out of pocket (CPI)– Full weight of medical, etc. (PCE)– Businesses and Gov’ts too (GDPur or GDP)– All transactions (PT = MV)– “Environmental” factors are in a true COLI

This can matter quantitatively• Not included in studies of measurement

error– Implicitly take scope as correct

• Example 1: Medical prices– Full weight in CPI: raise weight by factor of

four, would boost CPI about .25 pp per year– Same order of magnitude as other well known

categories of bias (but opposite sign)

• Example 2: European HICPs– Omit owner-occupied housing– Owner-occupancy shares (2002):

• Spain 85%• Italy 80%• Denmark 51%• Germany 42%

– “Harmonize” methodology by de-harmonizing scope