Inflation Measurement and Monetary Policy David Lebow Federal Reserve Board May 13, 2008

Central banks use inflation for different purposes Internal analysis and forecasting –No single measure best –Core inflation useful Public communication –Clarity and simplicity are virtues So stick to one price measure –Overall inflation important

Under-studied topic: Scope What price measure should a central bank most want to stabilize? Must it be a consumer price? Depends on perceived cost of inflation –New Keynesian literature: relative price variability affects resource allocation –Fischer-Modigliani (25 direct effects plus 25 indirect effects) –Money illusion and long-term planning

On whom do the largest costs fall? Possible scopes –HH out of pocket (CPI) –Full weight of medical, etc. (PCE) –Businesses and Gov’ts too (GDPur or GDP) –All transactions (PT = MV) –“Environmental” factors are in a true COLI

This can matter quantitatively Not included in studies of measurement error –Implicitly take scope as correct Example 1: Medical prices –Full weight in CPI: raise weight by factor of four, would boost CPI about.25 pp per year –Same order of magnitude as other well known categories of bias (but opposite sign)

Example 2: European HICPs –Omit owner-occupied housing –Owner-occupancy shares (2002): Spain 85% Italy 80% Denmark 51% Germany 42% –“Harmonize” methodology by de-harmonizing scope