Overall inflation rate best guide for monetary policy

Consumers complain that “everything's getting more expensive”, while official statisticians and euro-area central bankers assure us that "the general price level in the euro area has increased only moderately over the past ten years". Some critics would like to narrow the range of the goods and services included in the measurement of prices. They argue that "especially volatile components such as energy and food should be excluded from price measurement”. How can all these different views be reconciled? Are price developments in the euro area underestimated or overestimated? If we look into the workings of price measurement techniques, we find that, for monetary policy purposes, the officially measured overall inflation rate is the best guide. This is because this measure is comprehensive and shows at an early stage if persistent pressure on prices, including for energy and food, threatens to become entrenched, thus being able to trigger a perceptible sustained rise in the general price level.

The Harmonised Index of Consumer Prices (HICP) is an objective and methodologically well founded measure of price changes. It measures price developments using a representative basket of goods representing the most important goods and services that a typical consumer buys. Thus, the HICP makes losses in purchasing power comprehensively transparent.  It is precisely this characteristic of the index that some critics interpret as a disadvantage, particularly if temporary, random disruptions – such as crop failures or temporary oil price surges – occur. They advocate monetary policy being based to a greater extent on what are known as “core inflation rates”. Core inflation rates adjust the HICP for components that are particularly vulnerable to disruptions. The most prominent example of this in the euro area is the HICPex which excludes the components “energy” and “unprocessed food” (for example, meat, fish, fruit and vegetables) from the HICP (see chart 1).

Core rates provide very valuable information about the causes of price developments, but are not the best yardstick for assessing price stability. For a stability-oriented central bank it is ultimately unimportant to know for what reason or as a result of which price increases the goal of price stability is threatened. The average consumer is affected by all losses of purchasing power, regardless of whether they are caused by goods with or without strong price fluctuations; they do not live in a world in which they neither eat nor use transport. Furthermore, commodity price developments over the past few years show that components which are vulnerable to disruptions, and are therefore excluded from the core rate, can trigger not only short-term jumps in the general price level but also a sustained increase in the trend price level. For example, the sharp rise in oil prices, which continued into the summer of 2008, pushed up euro-area overall inflation rates for several years; this is not likely to be ignored by the Eurosystem. Finally, core inflation rates often follow the overall inflation rate. Prolonged rises in energy and food prices can, for example, push up the core inflation rate in the medium term through higher prices for public transport and in restaurants (indirect effects) and wage increases (second-round effects). Therefore, a monetary policy that is systematically geared to the core inflation rate runs the risk of overlooking the first warning signs of such inflation trends.

The exact opposite criticism, ie that the officially measured HICP understates actual price developments, is not valid either. A good example of this is the euro-area-wide debate on the perceived hike in prices which emerged when euro banknotes and coins were introduced in January 2002. In Germany, the neologism “teuro” ( = “expensive euro”) expressed the perception that the introduction of euro cash had led to a sustained surge in inflation. It is not possible to confirm this impression, however. Studies carried out by the Federal Statistical Office and the Bundesbank show that prices did go up in connection with the introduction of euro cash but not to the extent perceived by the general public. At 2.1%, the inflation rate in Germany in January 2002 was higher than the figures for the months before and after the introduction of the euro. However, many of the price increases were not connected with the euro but were due instead to other factors, such as very cold winter weather as well as higher taxes on energy, tobacco products and insurance. Although there were very noticeable price movements, particularly in the case of some locally offered services such as visits to restaurants, cinemas and hairdressers, the introduction of euro cash itself accounts, at most, for 0.3 percentage points of the January rate of 2.1%. This also explains why, during the changeover to euro cash, many consumers felt that inflation was much higher than shown by the official statistics. However, this is no reason to cast doubt on the concept of inflation measurement generally.

A conceptually convincing measure of “perceived” inflation has not yet been developed. However, survey results from the European Commission (see chart 2) show that it was not only during the introduction of euro cash that households’ perceptions diverged from general price developments. Generally speaking, there are various reasons for the divergence between the individual price perception of the consumer and the officially measured price statistics. First, many consumers mainly notice changes in the prices of goods which they buy frequently and/or pay for in cash (for example, food, petrol, clothes). By contrast, they notice favourable price trends to a lesser extent in the case of products which they rarely buy, such as cars, refrigerators, cameras and computers. Second, many consumers still compare current euro-denominated prices with D-Mark-denominated prices from the period before 2002 and forget about inflation in the seven years that have intervened.  Moreover, most of the price increases of the past few years would have occurred even if a single currency had not been introduced. This applies, in particular, to the surge in prices that was triggered by raising the standard rate of VAT in Germany by 3 percentage points in 2007, but also to the sharp rise in energy and food prices.

At all events, "personal" inflation rates tell us a lot about individual consumption habits and selective perceptions, but little about the general price trend. This is because hardly any consumer's purchases exactly match the average basket of goods of the statistical offices. Therefore, subjectively perceived inflation rates cannot be compared directly with officially measured inflation rates. Taken overall, measures of the perception of inflation can, at best, provide certain clues about the general public’s assessment of price developments. Only the official measurement of overall inflation, which is based on representative consumption habits, can be a guide for monetary policy. HICP fulfils this role. Of course, certain changes in the composition of the HICP can be useful, for example, including the prices of owner-occupied housing. However, there is no convincing reason why the Eurosystem should not continue basing its monetary policy on a representative consumer price index in future.