While central bankers fight to bump up inflation, people think there is too much of it.
There is something wrong with inflation. While central banks are multiplying the packages and undertaking other extraordinary measures to boost inflation. People on the other hand, think there is too much inflation. Most households think the average rate of inflation in the eurozone was 9 per cent between 2004 and 2018. This is odd as it was in fact 1.6% during this period. In the UK, polls show that people believe inflation is twice as high as the Bank of England says.
A recent paper published by economists from Essex University named “Central Bank Announcements : Big news for little people”, examined the effect of central bank communication to the average citizen. It found that that communication by central banks has little measurable effect on households’ perceptions of inflation.
Central bank have failed to explain their actions to average citizens and the information gap might soon become a real problem. Central bankers continue to act as if inflation is too low and take measures to boost it, mostly buying bonds and cutting the interest rates. However, these measures contribute to raising assets prices, including housing, which explain the perceptual difference between economists and individuals. For example, in Amsterdam, house prices rose by 64% during the last five years, while incomes only rose by 4.4%. This is a problem for the young generation as it delays the entry of first-time buyers to the market. In 1990, a generation of 35-year-old Americans owned ⅓ of the housing market in value. In 2019, a similar generation would only own 4% of the housing market . These developments have led to critics arguing that central bank policies are exacerbating a divergence between income levels and housing prices.
Emmanuel Todd, a french social scientist, is one such critic, focusing on the much-discussed debate on how to measure inflation. Todd argues that the current course is driving a decline in french households’ standards of living at a rate not seen since the post-war period. In his book, “Class Struggles in France in the 21st Century”, he accuses the INSEE, the French statistics bureau, of wrongly capturing the evolution of prices, noticeably by underestimating the importance of housing in the calculation for inflation: “in the INSEE world, the share of the income that French households spend on housing is either negligible or non-existent”. According to Todd, housing would represent only 6% of the total expense for french households.
Todd is right to point fingers at the way inflation is measured as failing to capture the rise in housing prices. However, he is very wrong in blaming the INSEE and accusing it to be under ideological constraint. The fact is the INSEE never said it was measuring the evolution of living standards but the evolution of the consumer price index, from which inflation is calculated. CPI is made by compiling changes in prices of an average basket of goods of an average household.
In France, the INSEE uses the Laspeyres index. It tracks behavior of price according to their importance, they are weighted according to the average household pattern. The weight is calculated from a detailed consumption survey representing as faithfully as possible the average French consumption, which represents a panel of 1,100 goods and services, from what more than 400,000 prices are collected each month.
This formula allow statisticians to track the evolution of price over time for a representative basket of goods and services. However, it is accused of overestimating inflation by not taking into account changes in consumption habits. Indeed, products can be substituted, discounted or new products can even be introduced. The change in price can also result from an improvement in quality.
It is crucial for central banks to have the best picture in the changes of prices, so the CPI needs to be calculated with precision. Indeed, monetary policy should react to permanent shocks and accommodate transitory ones, but not react to temporary changes. This is why they also exclude volatile items such as agricultural and energy products. Central banks use inflation as a guide for monetary policy, then it needs to capture the trends in the evolution of price, not one off changes.
Responding to the critics, Benoit Ourliac, administrator at the INSEE, says that the attack is completely misguided “The suspicion that the Ministry of Economy and Finance is interfering with INSEE’s calculation of inflation is ridiculous. Above all, it shows a total ignorance of the conditions under which the CPI methodology is drawn up” . He recognizes that the standings level decreased during the financial crisis but it recovered in 2016. Moreover, the INSEE is not trying to underestimate the share of housing in total expenses, and the figure 6% represents an average for the french population. Actually, the cost of housing would be 14% taking into account all the charges (water, gas, electricity). Thus, that figure does not reflect the different realities between tenants, who represent only 4 out of 10 households, and for whom the share of rents in their budget is actually 20%; from the owner, 6 households out of 10, who by definition do not pay any rent. And for those owners refunding a loan, the payment of interest is taken into account. The reason why the INSEE does not take into account the purchase of real estate, is because they consider it as an investment and not an expense.
Policymakers have a precise measure of inflation, and continue to do everything in their power to increase it. Still, their measure of inflation does not correspond to what people experience and it might be soon unsustainable for citizens. Central banks need to communicate in a more efficient way. Inflation targets are easy to communicate to the public, but it should not be confused with the inflation forecasts. Moreover, the CPI should not be mistaken by the public for a standard of living indicator. We can hope that the two strategic reviews put in motion recently by both the ECB and the FED will make it clearer for the average citizen.
Lastly, to reopen discussion about the side effect of the current monetary policy and the rise of social inequality, it may be time to think about creating a standard of living indicator. For one, adding real estate in the measurement of inflation could help preserve financial stability and prevent bubbles.
Written by Bastien Rébéna. Edited by Ebin Tomy, Jeppe Damberg.