The challenge of measuring inflation...when business is not as usual. CEPS Working Document No. 306, October 2008

The recent surge in commodity prices and the European Central Bank’s decision in June to raise interest rates to combat inflation have ignited a debate about the appropriateness of raising interest rates during a phase of weakening activity. In addition, it is relevant to examine the approaches to measuring the rate of inflation, to consider the advantages and drawbacks of these methods, and finally to throw new light on the possible influence of monetary policy on the fundamental trends in prices. This paper presents a critical review of the methods of measuring inflation for the euro area and the US, analysing i) the adequacy of the consumer price index (CPI) weighting scheme, ii) the different definitions of inflation used on the two sides of the Atlantic, iii) the drawbacks of the current measures in the face of changing times and iv) some alternatives for the inflation computation. As far as the weighting scheme is concerned, the main finding is that the weighting scheme applied by the US CPI exaggerates the weights of education, food and energy, while in Europe the weights in the CPI are closer to the expenditure weights with the exception of the weights of restaurants and hotels. Furthermore, this paper asserts that substitution among different categories of spending – as consumers and producers shift e.g. towards cheaper energy or food sources or less energy-intensive goods and services – might bias standard measures of price increases. To the extent that the standard measurement of inflation fails to take account of the scope for substitution, this will also have an impact on the measurements of real income and output. The paper therefore argues in favour of calculating and publishing the results of alternative weighting schemes for measuring inflation