Wonkblog’s Matt O’Brien had a great reminder last week that Eurozone policymakers’ obsession with low inflation is fueling a monetary policy that is extremely damaging to the broader European economy and the lives of millions of Europeans. A recent paper, though, suggests the problem may be even worse then we thought.

Jessie Handburt, Tsutomu Watanabe, and David E. Weinstein recently published a paper that purports to have assembled “the largest price and quantity dataset ever employed in economics” to assess how well the official Japanese CPI is measuring inflation. The answer is ‘not so good’ – but the reason for that answer is scary. To wit:

We show that when the Japanese CPI measures inflation as low (below 2.4 percent in our baseline estimates) there is little relation between measured inflation and actual inflation. Outside of this range, measured inflation understates actual inflation changes. In other words, one can infer inflation changes from CPI changes when the CPI is high, but not when the CPI close to zero.

What does that mean? They draw two clear conclusions. Firstly, that national CPIs routinely overstate inflation – here is their (better) measure stacked against the official measure:

the decline and fall of the nippon yenmpire

Since 1993, the official Japanese statistics show a net decline in prices of just a few percent, whereas the authors’ numbers show a decline close to 15%.

The other conclusion is that, even though over the long term the CPI overstates inflation, when inflation is low, the CPI is basically no better than a random guess as regards any particular measurement.

find the pattern [hint you can't]

This means that while, on average, the CPI inflation rate is biased upwards by 0.6 percentage points per year, one can only say with 95 percent confidence that this bias lies between -1.5 and 2.8 percentage points. In other words, if the official inflation rate is one percent per year and aggregate CPI errors are the same as those for grocery items, one can only infer that the true is inflation rate is between -1.5 and 2.8 percentage points. Thus, a one percent measured inflation rate would not be sufficient information for a central bank to know if the economy is in inflation or deflation.

you say toe-mae-tos (are more expensive) i say toe-mah-tos (aren't) let's call the whole thing off

In case it wasn’t clear enough, Europe is definitely in the ‘flying blind’ zone:


As is more and more of the developed world in general:

if all the other countries were blowing up their economies to satisfy a bizarre price stability fetish would you do it too?

This is, errr, kind of terrifying. Because what it all adds up to is the conclusion that monetary policy makers are throttling growth because they’re relying on data that is both inaccurate and imprecise. The inflation fears that have crippled Western recoveries for half-a-decade and running are based purely on phantoms.