But it is not true that price inflation is generally low. It simply happens outside of the official numbers, and most people feel it.

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Karl-Friedrich Israel

Every once in a while economists want to go out on a limb with their models and publicly make forecasts on what the future rate of price inflation will be. The current COVID-19 lockdown is no exception. Many economists have warned us of potentially very high rates of price inflation, because monetary stimulus on a massive scale meets a negative supply shock. Others are afraid that the monetary and fiscal stimuli won’t be strong enough to compensate for the drop in private spending, resulting in a deflationary spiral. More often than not, both parties are wrong.

It seems important to ask what it is that they try to forecast and how closely connected it is to monetary policy interventions. When we look at the consumer price inflation rates in the eurozone, there really has not been much going on over the past decades, despite a rather activist monetary policy. Since 1999, the average annual inflation rate, measured by the Harmonised Index of Consumer Prices (HICP), has been about 1.65 percent. The rate for any one year never went above 3.2 percent—the value reached in 2008—and was negative only once, in 2015, at –0.6 percent. So, all in all that’s a fairly narrow band, and the average aligns rather nicely with the Eropean Central Bank’s (ECB) stated target, although some economists would like to see it even closer to 2 percent.

Figure 1: Year-on-Year Percentage Change from January of the Previous Year to January of the Respective Year

Sources: ECB, IMF. The explanatory gap is defined as the growth rate of M1 minus the growth rates of the HICP and real GDP.

In contrast, the eurozone’s M1 monetary aggregate has grown at an average annual rate of 7.59 percent over the same period (1999–2020), which means that it has much more than quadrupled, whereas consumer prices have only grown by a bit more than 40 percent. One would not expect all of the monetary expansion to translate into proportional price inflation, but the observed gap is surprisingly large and persistent. Real economic growth according to official numbers hardly fills it. Real GDP has grown by merely 32 percent since 1999, or by an average annual rate of 1.35 percent. A back-of-the-envelope calculation by which we subtract both the average real growth rate and the average rate of consumer price inflation from the average growth rate of the money stock M1 leaves us with an explanatory gap of about 4.6 percent per year. Where does the money go if it is not absorbed by higher unit prices for consumer goods or a larger real output?

Well, there are essentially two possible explanations. First, there may have been increases in the reservation demand for money. Put differently, there may have been a substantial decrease in the velocity of money. Indeed, if one believes that the quantity equation—PY = MV, where P is the HICP, Y is real GDP, and M is the money stock M1—accurately relates the empirical magnitudes considered, then yes, velocity (V) must have taken up the slack. But since velocity here is merely residual, it explains the entire gap simply by definition, which is to say that it does not explain anything at all. There surely are changes in the reservation demand for money, but should they be so persistently positive every year? And why should they be so high (see Figure 1)?

The second possibility is that inflationary pressures actually materialize outside of consumer goods industries, most notably in the markets for long-term assets, such as stocks and real estate. This would imply that the HICP inflation measure grossly underestimates the general rate of price inflation. The surge of asset price inflation over the past decades has been widely documented, and this clearly matters to the average household. When asset prices rise it becomes harder to attain any given level of real wealth if you are not there already.

Figure 2: HICP Inflation Rates and the Median Inflation Perceptions in the Euro Area since 2004

Source: Business and consumer survey database, European Commission.

The answer lies most likely in some combination of these two causes and some other factors. But the second cause—inflationary pressures outside of consumer goods industries—seems to be the more important one. It is especially important if we want to evaluate how well average citizens are actually doing. And it turns out that if we listen to what they have to say, we find a rather interesting empirical result.

Since 2004, the European Commission has published survey data on inflation perceptions. Figure 2 shows how those perceptions compare to the HICP inflation measure from 2004–19, the period for which data on inflation perceptions is available. The geometric average of the median perceived inflation rate over this time was 6.57 percent. Over the same period, the measured HICP inflation rate was 1.57 percent. So, on average, median perceived inflation has been 5 percentage points higher than the official rate of consumer price inflation. The average explanatory gap as defined above has been 4.8 percentage points, which is remarkably close to what the median respondent in the survey perceives to be the difference between actual and measured inflation (5 percentage points). The difference between perceptions and official numbers fills the gap quite nicely.

Now, it is very likely that perceptions are upward biased,1 but it is hard to believe that they completely miss the mark. The overall inflationary pressure does not seem to be covered by the official HICP numbers. In fact, the latter tend to be rigid relative to asset prices. This, among other things, has given monetary policymakers comfortable wiggle room for engaging in ever more expansionary measures without failing to remain below the 2 percent target. But it is not true that price inflation is generally low. It simply happens outside of the official numbers, and most people feel it.

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