The FED has recently announced a major policy change: instead of aiming for an inflation rate of 2%, it will aim for an average inflation of 2%. This means that if in some periods the inflation is measured below that value, the FED will allow it to rise above 2% to compensate. Most of you probably do not know it, but this is not the first trick central banks use to manipulate the markets more and more while pretending no distortions on the prices are produced. The most subtle and at the same time simple of these tricks lies in the way they measure inflation.
Let's keep the focus on the FED. The FED uses the Personal Consumption Expenditure (PCE) as inflation index. Why using that index and not the Consumer Price Index (CPI)? There are several reasons, but one in particular is of interest for us now. As you might know, an inflation index is computed as a weighted average of the price changes of a set of goods and services. The PCE and the CPI use two different sets, but the most important difference is that the PCE is computed accounting for the "substitution effect". Basically, this means that if the price of a certain good goes up, but there is a cheaper good the guys who compute the index think can substitute the other (according to them!!), they kick out from the index the good whose price increased and they include instead the good whose price is lower. This of course leads to an underestimation of inflation, although for some reasons obscure to me, the general consensus is that it's CPI which is biased for not accounting for the substitution effect, and not the other way around. So, if there is a certain good you like and you regularly buy, and its price increases, you HAVE to swap it with something cheaper according to those guys. Ehr...ok. Obviously, the CPI is consistently higher than the PCE [1].
I could go on and mention the fact that many goods whose price regularly increases are never included in those indices. For example, in many european countries the price of alcoholic drinks and tobacco doubled in the last 15 years, but this was not even registered in national inflation indices, because they are not included in the set of goods used to compute them. Apparently, those guys are concerned with your health and think you should not consume those goods anyway, so why bother including them?
So, long story short, if you want to know what the real inflation rate is, take the official rates and add 1 or 2 percentage points, and you might get some realistic figures.
This sums it up regarding inflation that affects "real" goods and services. What about inflation on the financial markets? In case you did not notice, we are in the middle of one of the worst economic crisis ever, and stock markets, after an initial dramatic crash, mostly recovered, and the NASDAQ is even breaking new records. "Maybe" it has something to do with the tons of money central banks are throwing in?
P.S. Aside from the questionable way inflation in computed, I think central banks should aim for a 0% inflation rate, but that's another story.
[1] The CPI vs PCE figure was originally posted here.
