As talk of a new recession grows louder, everyone is
watching some favorite indicator. The yield curve, claims for unemployment, the
quits rate — you name it. What surprises me is how few people are watching an
underappreciated indicator from the New York Fed that uses more than just price
data to tell us what is happening with inflation.
What makes the Underlying Inflation Gauge (UIG) unique is
its power to distinguish between changes in the cost of living and changes in
the rate of inflation. Did you think those were the same thing? Think again,
and read on.
What’s the difference?
The concept of the cost-of-living stems from the first of
those role of money as a medium of exchange. When we say the cost
of living increases, we mean that it gets harder to maintain a given standard
of living on a given income. Either we have to be satisfied with fewer goods or
services, or save less, or work harder. In the language of economics, a change
in the cost of living is a real phenomenon.
Inflation, in concept, is best understood a change in the
value of our unit of account, the dollar. When there is inflation,
the value of the unit is smaller each day than it was the day before, for all
transactions.
Imagine that you woke up one morning to find that someone
had chopped an inch off all our rulers, so that today’s foot was now only as
long as yesterday’s eleven inches. You might go from being six feet tall to
six-foot-six, but it wouldn’t be any easier for you to reach the top shelf in
the kitchen without a footstool. Similarly, if inflation raises both your
income and the prices of everything you buy by the same percentage, the value
of a dollar as an economic ruler shrinks, but it is neither harder nor easier
to maintain the same real standard of living. In that sense, inflation does not
measure anything real. It is a purely nominal phenomenon.
There are two other important differences between inflation
and changes in the cost of living.
First, although they are both harmful, they are harmful in
different ways. An increase in the cost of living hurts people because it makes
them poorer. The harm from inflation is more subtle. Inflation makes it harder
to plan for the future, so it discourages investment. It erodes the real value
of cash and other assets that have fixed nominal values, so it discourages
saving. Because the rate of inflation typically becomes more variable as it
becomes more rapid, it increases uncertainty. People can overcome some of the
uncertainty by indexing the contracts they make, but indexing is costly and
never perfect. When we take all these effects together, inflation makes markets
work less efficiently and slows economic growth.
Second, the effects of inflation are the same for everyone,
but changes in the cost of living vary from place to place and from person to
person. If inflation shrinks the unit of account by 3 percent, then the real
values of anything with a fixed nominal value — a paycheck, of a Treasury bond,
or of a contract to deliver goods — all fall by 3 percent. In contrast, a
change in a broad index like the consumer price index (CPI) affects people’s
cost of living differently according to which components change. An increase in
the price of heating fuel affects people in cold regions more than those in
warm regions. An increase in the price of meat does no harm to vegetarians. The
cost of living in New York does not necessarily keep pace with that in Oklahoma
City.
Can we measure inflation and the cost of living
separately?
The CPI is primarily a measure of the cost of living. Each
month, the BLS gathers data on the prices of hundreds of goods and services.
After making adjustments for changes in package sizes, and, periodically, for
changes in quality, it reports the result as a weighted average. If your
consumption patterns are reasonably close to the average, the change in the CPI
tells you how much harder or easier it is to maintain your standard of living
on a given nominal income.
We can take the CPI at face value as a measure of the cost
of living, but we have to do some work to extract information from it about the
rate of inflation.
A good first step is to adjust the CPI for predictable
seasonal changes in the cost of particular goods. For example, everyone knows
that the price of fresh vegetables goes up when the summer harvest season is
over, but if we expect the price to go down by the same amount next summer, we
don’t count the seasonal change as inflation. Consequently, the BLS reports the
monthly CPI in both a seasonally adjusted version and a version without
seasonal adjustment. Adjusting the raw CPI for predictable seasonal changes
greatly smooths month-to-month volatility. We can also get rid of seasonal
variations by looking at the CPI for any given month compared to its value 12
months earlier.
Another way to extract an inflation signal from the noise of
month-to-month changes in the CPI is to sort out price changes that have
particular, microeconomic causes from those that have more general,
macroeconomic causes. Microeconomic causes include things like extreme weather
events, wars, or developments in global commodity markets. Macroeconomic causes
include changes in monetary policy, changes in fiscal policy, and the state of the
business cycle.
Food and energy prices are particularly susceptible to
transient microeconomic events. To sift them out, the Bureau of Labor
Statistics publishes a so-called core CPI, which
removes the food and energy components. As the following chart shows, the core
CPI is considerably less volatile than the CPI itself, even when the CPI is
averaged over 12 months, so it gives us a better idea of the underlying rate of
inflation.
An even better way to measure inflation
But, economists at the New York Fed think there is an even
better way to measure inflation. Instead of removing data from
the CPI to get rid of the noise, as the core CPI does, why not add data
to get more information on underlying trends in the unit of account? The
additional data used by the New York Fed includes real variables, like
employment and output data; monetary data like trends in the money stock; and
financial data like interest rates and bank credit. Subjecting all of this data
to a complex filtering procedure gives the Underlying
Inflation Gauge. The New York Fed supplies monthly values for the UIG going back to 1995.
Here is what we get when we put the three inflation series
together:
First, we see that the UIG, like the core CPI, tends to
smooth the data. It is not as volatile as the CPI itself, but it is a little
more volatile than the core CPI. That already tells us that it has some value
in filtering out the inflation signal from the cost-of-living noise.
More importantly, though, the UIG is much more sensitive to
cyclical variations in the economy. Although the UIG only goes back far enough
to capture two previous recessions, what it shows us is highly suggestive.
In June 2000, the rate of change of the UIG began a
sustained decrease some nine months before the start of the short recession
that began in March of 2001. The UIG continued to slow throughout the
recession. In contrast, the rate of inflation as measured by the CPI remained
high and more volatile during the recession, and the rate of increase in the
core CPI actually rose.
A similar pattern can be seen going into the much deeper
Great Recession that began in December 2007 and lasted until mid-2009. The rate
of change of the UIG began to slip well before the recession started, and fell
steadily once it was well under way. In contrast, inflation as measured by the
CPI itself increased in the early months of the recession, and the rate of
change of the core CPI was actually higher a year after the onset of the
recession than when it began.
The bottom line
A word of caution: The above is only “eyeball econometrics.”
We don’t have a long enough data series for the UIG to give statistically
conclusive results. But, with that disclaimer in mind, if you’re looking for
early warning signs of an impending recession, I’d keep my eye on the UIG
rather than either of the other two measures of price trends.
The UIG has been falling for 10 months now. True, it gave a
false alarm with a similar decline starting in mid-2011, but this time the
downturn in the UIG coincides with other worrying trends in world trade and
financial markets. It just might mean something.
Previously posted at Medium.com
No comments:
Post a Comment