Bundesbank investigates measurement bias in the inflation rate

The Harmonised Index of Consumer Prices (HICP) is the key indicator used to measure price stability, and thus orient monetary policy, in the euro area. Consumer price indices such as the HICP are typically used to measure the change over time in the prices of a representative basket of goods and thereby calculate the rate of inflation. When measuring these price developments, however, various types of measurement bias may arise. For example, if more money is spent on certain goods and services, they will be given higher weights in the index the next year, and vice versa. However, such adjustments to the expenditure weights of individual items in the basket of goods are generally only reflected in the consumer price index after a certain time lag. The price change indicated is thus not entirely representative until that time has passed.

The researchers at the Bundesbank have therefore retrospectively investigated the accuracy of HICP measurement in Germany during the period from 1997 to 2019. Their study found that, if expenditure patterns had been accurately reflected at all times, the inflation rate in Germany would have been around one-ninth of a percentage point lower on average. “Around 80% of all deviations fall within a range of 0 to 0.25 percentage point,” explain the economists in their research paper. According to their assessment, while the distortions caused by not entirely representative weighting are generally rather small, they constitute just one source of potential measurement bias in the HICP. For example, the analysis did not take into account distortions caused by new products being introduced into the basket of goods with a delay or by statistical processes being unable to precisely identify qualitative improvements to products.

For their investigation, the researchers calculated a reference index that reflected actual price developments with a greater degree of accuracy retrospectively than the HICP. This was possible due to the researchers having access to better information at the time of their analysis than had been available at the respective points at which the HICP was calculated. First, they had more data on households’ final consumption expenditure and were thus able to more accurately calculate how high the weights for specific goods and services in the index should have actually been. Second, the economists used a formula that, unlike the one used to calculate the HICP, factors in the basket of goods from a given year in addition to the basket of goods from the year prior. The researchers then compared the inflation rates based on their reference index with the published inflation rates. In doing so, they were also able to determine that the distorting effects of formulae and preliminary data are, on average, about the same.

Price stability is achieved when there is very little movement in the price level despite individual prices fluctuating in the markets. Thus far, the ECB Governing Council has defined price stability as a year-on-year increase in the HICP for the euro area of below 2%. Within the scope of this definition, it aims for a rate of inflation of below, but close to, 2% over the medium term. The wording of this definition makes clear that not only inflation of more than 2%, but also deflation (i.e. a decline in the price level), is incompatible with price stability. The aim of “an increase in the HICP of below, but close to, 2%”, also takes account of possible measurement bias in the HICP as well as the potential effects of inflation differentials in the euro area. The ECB is currently reviewing its monetary policy strategy and is revisiting its inflation aim as part of this exercise.