Fool's Trap: Measuring Inflation

By Grant de Graf

Probably one of the most frightening economic phenomena is the restrictive way in which bankers and economists are measuring inflation. These indicators are being used to make game changing decisions that invariably could exacerbate weakness in fragile economies.

Take the Euro-Zone's latest reading for inflation which came in at 2.4% in February, 2011 from 2.3% in January, the highest level since October 2008 and unchanged from the preliminary, or flash, estimate published on March 1, by the European Unions' Eurostat agency.

Let's also look at the report for the rise in consumer prices in the U.K. which "grew at an annualized pace of 4.4% in February to mark the highest reading since October 2008, while the core rate of inflation increased 3.4% from the previous year amid forecasts for a 3.1% expansion."

Typically inflation is measured by changes in the consumer price index [CPI] which provides a very limited perspective on the inflation that central bankers need to address.

The accepted practice for dealing with inflation and an economy which is over-heating, is to spike interest rates. The only problem is that we don't really have an economy that is overheating and that advances in the CPI appear to be a consequence of the demand and supply curve, rather than changes in monetary supply or business activity.

For example, unrest in the Middle East has been the cause for a rise in crude prices, which has caused an increase in fuel prices at the pump and in transport costs. The multiplier impact that this has on an economy is obvious. Secondly, the hike in food prices internationally, partially as a result of shortages, has also effected the CPI.

The fallacy that governments can raise interest rates to reduce inflation, which is essentially a function of demand and supply is misplaced. Most certainly, if trading levels of the Sterling and the Euro are anything to go on, the market believes that central bankers will increase interest rates to combat the recent increases in CPI, which they are calling inflation. Such a move by policymakers, in this instance would be a mistake. Changes in prices within any market mechanism is a natural function that contributes to the equilibrium process and the efficient distribution of goods.

When money supply within an economy increases, or robust growth is the cause for higher prices, then there may be justification for a government to use interest rate policy to curb an overheated economy. That is not the case here.

A more accurate way to measure the harmful effects of inflation that governments seek to constrain, is to track increases in real wages and decreases in unemployment, to access the impact that inflation is having on an economy.

Case in point, WSJ reports:

"Eurostat said wage growth in the euro zone picked up in the final three months of last year [2010] from its record-low pace, although pay still rose less rapidly than prices.

"Employment edged up only modestly over the final three months of last year, so consumer spending appears unlikely to grow rapidly in the months ahead or make a major contribution to growth in the broader economy."

Clearly, the recently reported increases in CPI, both in the United Kingdom and the Euro Zone do not justify for an increase in those region's interest rates. The impact of increasing interest rates would further constrain growth in fragile economies, and would not have an impact on CPI, in the way that governments may desire.