How to measure inflation going forward

The COVID inflation

In this paper, Alberto Cavallo, constructed updated weights of different spending categories in the CPI which reflect the relative share of these categories of goods and services  of total household consumption during the pandemic crisis. He used data from US credit and debit card transactions for the first four months of 2020. He found that by April, two categories — “food at home” and “transportation” — diverged substantially from the current CPI weights. Using the updated weights, Cavallo re-computed the US inflation rate. His findings include:

• As of April 2020, the annual inflation rate in the United States was 1.06 percent, as compared with 0.35 percent as reported by the CPI;
• The implication is that the pandemic will continue to increase the cost of living for the average US consumer. The gap between the official CPI and the COVID-19 inflation index will continue to widen as new social-distancing measures shift spending away from categories experiencing minimal inflation;
• Under the assumption that the changes in spending patterns in other countries mirrored those in the US, he constructed COVID CPI indexes for 16 other countries as well. He found that in 10 of the 16 countries, inflation rates during the pandemic were higher than the official rates.

Inflation with Covid Consumption Baskets
Authors: Alberto Cavallo
From: Harvard University

The inflation in carbon prices

The transition to a low-carbon economy by 2050 implies an increase of the price of carbon. Going forward therefore the relative price of energy will be volatile and rise.

The unavoidable conclusion, then, is that the ECB will have to abandon the HICP index and use core inflation indices that exclude energy and food prices. The reason is not just that core inflation is a more reliable indicator of the lower-frequency component of inflation. Rather, it is that monetary policymakers will need to distinguish between price changes that are occurring for good reasons (as a result of desirable structural changes) versus price changes that indicate a temporary imbalance between supply and demand. The ECB should seek to minimize only the latter category.

The Core of the ECB’s New Strategy
By: Hélène Rey – London Business School

How about underlying inflation?

Underlying inflation provides an idea of what the rate of price change is expected to be under “normal” circumstances in an economy where the level of resource utilization is putting neither upward nor downward pressure on inflation. Since the definition of underlying inflation is predicated on a state of the economy that hardly ever materializes, it must therefore be inferred from the behavior of actual inflation. In this policy note, Jeremy Rudd describes and assesses univariate, multivariate and survey based estimations of underlying inflation.

He finds that estimates of underlying core inflation, such as the ones he considered, will provide poor estimates of underlying total inflation under the expectation that relative food and energy prices will make a nonzero contribution to total inflation going forward.

Underlying Inflation: Its Measurement and Significance
By: Jeremy B. Rudd – Federal Reserve Board