Is the current rate of inflation way lower than we think?

We are all used to relying on the annual rate of inflation as a measre of price pressures. It fits in with our perceptions – prices are way in advance of what they were a year ago in many areas.

New research referenced in the latest Economic and Social Research Institute (ESRI) quarterly commentary, however, raises an important question, which is relevant in particular for central bank interest rate policy.

What is the rate of inflation running at right now? And the answer to that is that – in Ireland and many other countries – it is significantly lower than the annual figures suggest.

1. The background

Measuring inflation has, in recent years, been an uncontroversial operation because there hasn’t been much of it.

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When consumer prices don’t change that much, measuring the inflation rate is fairly straightforward, even if there have been periodic rows about what should be included and how to deal with issues like housing costs. But the huge price volatility of the last couple of years has changed things.

Now it is conceivable – perhaps even likely – that the rate at which prices are rising at a particular point in time is not reflected by the commonly quoted annual inflation rate of the consumer price index.

This does not mean that the annual rate is incorrect – but it may mean new measures are needed to try to gauge what is happening right now. This is particularly important for central banks like the European Central Bank, who determine their interest rate policy based on price pressures.

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2. The research

There have been a number of papers on the nature of the inflation that has hit the world economy, due to a range of demand and supply factors, particularly the surge in energy prices.

This has left analysts divided on how central banks should respond, with risks that they do not increase interest rates enough and allow inflation to become embedded, or that they move too quickly and push economies into recession. Given the unusual genesis of the current inflationary period, there are no “right” answers here.

A key issue for central banks is what data it uses – and also how it communicates this to the public. The latter is important because if people believe that the inflation rate is on the way up this can become a self-fulfilling prophesy – because they accept higher prices, demand increased wages and so on.

Having pushed up interest rates since last summer, central banks now face a dilemma. Do they move further and increase the risk of recession - or even financial turmoil? Or does not doing so create a risk of inflation becoming embedded through higher prices and, particularly, higher wages?

An influential recent paper by Jan Eeckhout of the UPF (Univeristat Pompeu Fabra) in Barcelona tries to come up with a way of measuring what he calls “instantaneous inflation”. (While some of the paper is technical, the discussion part is not).

He writes: “The conventional measure of inflation lives in the past: it puts a lot of weight on observations that are 12 months gone.” He believes his measure is a more adequate reflection of the current level of prices change.

His work puts much more emphasis on the latest readings of inflation than do traditional annual inflation measures and he comes up with a methodology that converts this into what might be called a current-run rate of inflation – what the annual rate might be based on what has happened recently.

This is a lot more complicated that just multiplying the latest monthly rate: what Eeckhout does is use a measure that puts more emphasis on the up-to-date figures and tries to factor out " noise” or distorting factors.

He estimates that in the US the “instantaneous” rate in December was 2 per cent, compared to the generally quoted annual rate of 6.5 per cent.

In the euro zone he puts the December rate at 4 per cent, compared to a headline reading of 9.2 per cent. Central banks use a range of measures of inflation, he points out, including the monthly rate. But he accuses policymakers and journalists of being too ready to rely on the annual rate, which gives a dangerously incorrect message to the public and affects their vital expectations of future inflation.

Eeckhout writes: “One of the most daunting challenges in controlling inflation is tenaciously high inflation expectations, which in turn affect firm and household behaviour: when inflation expectations are high, firms set high prices and households demand higher wages, resulting in high inflation as well as persistently high inflation expectations.”

3. What about Ireland?

The latest ESRI quarterly commentary (box A, page 37) applies the Eeckhout readings to Ireland. It looks at the January annual consumer price inflation (CPI) rate of 7.8 per cent – a measure that effectively gives equal weighting to inflation in each of the previous twelve months.

Using the Eeckhout methodology and giving more weighting to the more recent months brings the rate down to 4.2 per cent (see graphic above)

Again, it is important to emphasise that does not mean that the traditional annual rate is in some way incorrect – in fact it directly reflects the experience of consumers.

But what it does suggest is that because price pressures are so volatile, the traditional CPI method does not reflect what is happening at the moment.

The ESRI research shows that applying the instantaneous method gives notably different results than the CPI in volatile areas like energy prices and less so in food prices, which have risen steadily over the past year.

Much of this is due to energy prices. The ESRI research shows that applying the instantaneous method gives notably different results than the CPI in volatile areas like energy prices and less so in food prices, which have risen steadily over the past year.

Energy prices have started to decline in recent months – in areas such as petrol and diesel, for example – while food prices have marched steadily higher.

4. The dilemma for central banks

Having pushed up interest rates since last summer, central banks now face a dilemma. Do they move further and increase the risk of recession – or even financial turmoil? Or does not doing so create a risk of inflation becoming embedded through higher prices and, particularly, higher wages?

Some economists point to the 1970s, for example, when central banks’ slow responses to oil price shocks allowed inflation to take hold. Others refer to the mistaken decision of the ECB to increase interest rates in early 2011, which had to be quickly reversed.

Decisions are made more complicated by the delays, or lags, before official interest rate rises are passed on by banks and start to affect the real level of activity.

Some recent research has put these lags at six to nine months – previous estimates had been longer. Either way, the ECB now has to decide what to do in May, at a time when much of the monetary tightening it has already announced has not had its full impact. And when, if the Eeckhout research is correct, prices pressures may already have eased significantly. Who would be a central banker?