Measuring Inflation In the U.K. And Euro Area

247Bull.com Editor: The GDP deflator is confirming the signals being given by copper, base metals, many soft commodities and money velocity. All of these point to a very real risk of deflation, and both recent experience and monetary history show that policymakers will fight deflation with every tool at their disposal. The sad thing is that rather than embracing deflation as the true cure to the inflationary boom that led to the 2008 bust, politicians and central bankers will likely create yet another wealth-destroying bubble.

As the price index of all goods and services produced within the country, the GDP deflator is the truest measure of domestically sourced inflation (or deflation).

Measuring-Inflation-In-the-U.K.-And-Euro-Area

The Bank of England and the ECB – like most inflation targeting central banks – use the CPI to measure price inflation. But by definition, the CPI only includes the prices of goods and services purchased by consumers. This measure ignores prices in roughly 35% of the economy that is comprised of government spending, capital spending by firms, and goods and services made for export. A broader gauge of inflationary pressures is the GDP deflator.

When the CPI and the GDP deflator are giving the same message, there is no harm in choosing the CPI as the inflation target. Indeed, it has some advantages: the CPI is calculated monthly with short reporting lag times. In contrast, the GDP deflator is calculated quarterly, with some delay, and is then subject to revisions. Hence, the CPI is a much more user-friendly inflation index.

But when the CPI consistently clashes with the GDP deflator, policymakers must give precedence to the deflator. And intentionally or not, this is exactly what the BoE has done. Its QE programs over the past three years look incongruous with the CPI’s overshoot, but are completely consistent with the GDP deflator’s undershoot.

The bottom line

In both the U.K. and the euro area economies, the broadest measure of prices – the GDP deflator – clearly shows deflationary risks exceed inflationary risks: both the BoE and ECB have an economic justification for further monetary easing.

Article courtesy of BCA Research.com

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