Getting the inflation lowdown after lockdown

Tom Traill - 16 July 2020

In these turbulent times, there is a premium on accurate measurement. Many a government policy has been launched mid-crisis, based on false or incomplete information, leading to disappointment and regret. Vast commitments of taxpayer funds can thus be lost to waste, fraud and incompetence. The widespread belief that the general price level, proxied by the CPI, is about to crash has prompted some knee-jerk policy moves in recent weeks. The GDP deflator, though less timely, offers a more thorough measure of inflationary conditions than the CPI and is much more reliable in times of economic stress. It is less affected by the distortion to household spending patterns occasioned by the lockdowns and does not bear out the price-crash thesis. 

Figure 1 below shows the path of annual inflation for three global price series over the past twenty years. These move sympathetically particularly at major turning points but have differing amplitudes. Figures 2 and 3 provide the analogous data for developed and emerging economies. So far, inflation measured by the GDP deflator is holding up in DM while the CPI measures are tumbling. In EM, CPI inflation has been running well ahead of the GDP deflator measure, so the latter is unthreatened by a CPI correction. Extreme events, such as Covid-19, expose the quirks and flaws of index construction which are much more of an issue for CPI.

The CPI is the weighted change in prices for a basket of goods and services, but how many of these have been freely available in recent months? The CPI formula fails to capture significant shifts in consumer behaviour as sales in supermarkets increase drastically while restaurants are closed. Even the collection of the constituent price data becomes more challenging when everyone is told to stay at home. Indeed, India decided not to publish a CPI reading for the past two months due to its unreliability.

The GDP deflator however has a degree of reflexivity built in. While some countries provide a measure of the implied price index, we have derived the deflator from the nominal and real GDP data for both the aggregate and US measure. The GDP deflator is comprehensive and robust in the face of shifting patterns of public and private sector spending. Indeed, in the decomposition of the US GDP deflator shown in figure 4, services (under-represented in the CPI) and government spending were the major contributors to the steadiness of the deflator in Q1. The role of government as an independent inflationary force is especially relevant in times of crisis.

Each month we produce our Global Inflation Heatmaps publication, which includes the 53-country headline CPI aggregate. In January annual inflation was 3.5 per cent – the highest level in almost eight years. By March, this had fallen to 2.7 per cent and in May, to 1.7 per cent. Each quarter, we publish our GDP Heatmaps. Global inflation, based on the GDP deflator edged higher, to 2.1 per cent in Q1, from 2.0 per cent in Q4. In summary, CPI fell 50 basis points in Q1, our core (ex-food and energy) CPI measure fell 18bp and the GDP deflator rose 4bp.

While financial markets and policymakers are focused on the CPI as the headline measure of inflation, this is likely to lead to misjudged investments and poor policy decisions in current circumstances. The GDP deflator is slower moving, and less timely in its publication, but provides a better overview of inflation. As more businesses re-open we expect to see increased legislative costs on their activities, demands for higher wages from the poorly-paid key workers, increased acceptance of the higher costs imposed by onshoring and a greater understanding of the inflation embedded in global supply chains.

Figure 1

Data source: Thomson Reuters Datastream and EP calculations

Figure 2

Data source: Thomson Reuters Datastream and EP calculations

Figure 3

Data source: Thomson Reuters Datastream and EP calculations

Figure 4

Data source: US Bureau of Economic Analysis

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