Central Bank Biases: Inflation

Beyond human suffering, the effect of Ondoy is inflation – price increases resulting from reduced supply.

If the floods also destroyed inventories and product-making machineries, the prices of these products would likewise increase.

There is a solution to local supply problems – importation!

But if we import more than we export, our increased demand for US
dollars will depreciate the value of the Peso and lead to an increase
in prices.

How is inflation measured?

Governments have a way of measuring inflation.

Assume the price of a sack of rice is P1,000 and this price jumps to
P1,200.  The price increase is P200.  The inflation rate is 20%.


Beyond human suffering, the effect of Ondoy is inflation – price increases resulting from reduced supply.

If the floods also destroyed inventories and product-making machineries, the prices of these products would likewise increase.

There is a solution to local supply problems – importation!

But if we import more than we export, our increased demand for US dollars will depreciate the value of the Peso and lead to an increase in prices.

How is inflation measured?

Governments have a way of measuring inflation.

Assume the price of a sack of rice is P1,000 and this price jumps to P1,200.  The price increase is P200.  The inflation rate is 20%.

But people buy assortments of products and services.  How does the government take this assortment into consideration?

It made a survey of people throughout the country and asked them:  on what items did you spend your money last year? 

Then, the government gathered these lists, made a selection of representative products and put weights on them.

The resulting weights may appear as:  food at 50%, clothing at 3%, housing at 17%, fuel and light at 7%, services at 16% and miscellaneous items at 7% – a total of 100%.  These are the weights, in rounded numbers, used by our government today since 2000.  (Source: http://www.census.gov.ph/data/sectordata/2000/tab2.htm )

In the USA the relative weight for food is 16%.  Contrast that with our 50%.

Market Basket, the CPI and Inflation Rate

This assortment of expenditures is called fixed market basket.

Every month, the government makes a survey of prices of items in the market basket.  It determines price changes per item and then computes the rate of change of the item and multiplies that rate by the weight allocated to the item.

If the rate of price increase for food is 20%, then .20 is multiplied to the relative weight of food at .50.  The resulting index for food is .10.  Other products are then calculated in the same way.  The indexes for all products in basket are added to arrive at the price level for the period.

This is called the Consumer Price Index or CPI.

 To determine the rate of change in price levels, all we need to do is compare the index of the market basket for 2000, the base year, with the 2001 index.

The rate of change in price levels based on the comparison of the indexes of two time periods is the rate of inflation.

Central Bank biases

Central banks have a bias for accepting the inflation rates from the CPI detailed above as a basis for making changes in monetary policy.

This bias leads to the conclusion that all inflation rates beyond target (say, 3%) is wrong.  Such inflation diminishes the purchasing power of money.

This bias also leads to the conclusion that inflation can result in negative interest rate – meaning the inflation rate is greater than the earnings rates of money invested in banks or in financial markets.  This is discourages savings and investments.

To combat inflation central banks raise interest rates as their most effective weapon.

Erroneous Assumptions

Although the CPI is a good measure for inflation, it is not a meaningful measure.

A wealthy businessman earning P300,000 a month may likely spend less percentage of his expenditures on food than the .50 indicated in CPI weighted average.  In fact, he may spend much money on items not even considered in the market basket.   So, a price increase of 20% on a cavan of rice worth P1,000 will not translate an inflation rate of 10% (.20 x .50) but merely 2%.

On the other hand, a poor worker with a family of 4 with a P10,000 monthly pay may likely spend all his earning on food and still borrow for more food. His family will find the weighted average of  .50 for food false and the inflation rate a full 20%.

Here is another error.  The CPI merely indicates weighted average of expenditures of people. It does not consider the total amount of expenditures in the economy which impact on the actual level of demand for products.

Let’s say that in a population of 10 people, 7 are miserably poor with a total expenditure of P30,000 on food while 3 are rich with a total food expenditure of P90,000.

Which group drove the prices of food higher – the rich who are few or the poor who are many?

How about the food expenditures paid for by companies?  These are not considered in the CPI.

Under these conditions, how can raising interest rates be made effective if the CPI is not meaningful and does NOT reflect aggregate demand?

Finding solutions to root causes

In the case of high inflation from Ondoy, what will traditional central banks likely do?  Yes, increase interest rates,

But the cause of inflation is lost supply!

No matter.  To bring down inflation rate, make it harder for people to borrow, to spend, to consume so that aggregate demand is brought down!

If the cause of inflation is the depreciating Peso, raise interest rates!  Make it harder for people to borrow, to spend, to invest so that demand for imported products is reduced and prices go down!

Outlandish but true!  Finding the root causes of problems does not seem to fall within the realm of central banks’ authority!

Financial Markets vs. the Real Economy

Here is another policy resulting from the use of the CPI.

The US Central Bank maintains interest rate close to zero and ventures into quantitative easing on the pretext that it wants to boost the ailing economy and inflation is manageable based on the CPI.

The result? 

There is so much money in the financial markets. But that money has nowhere to go but speculative investments in stocks, futures, options and derivatives whose values beat the GDP of the USA not by percentage but by multiples!

Where does this speculation lead? Less money available to the real economy and increased prices of food, oil, steel, copper, gold in the commodities market in NYME and Chicago Mercantile Exchange. 

At whose expense?  People and businesses which have real need for those commodities.

Here is one thing clear:  Central banks do not consider increases in prices in commodities and stock markets inflation. 

Neither do central banks give due concern to wildly fluctuating foreign exchanges rates that result in increased costs and risks in the real economy.   If they did, they would have confronted the use of the US Dollar as the world’s exchange rate and found an alternative.

What is the justification for all these?

Why, big banks make money on speculative transactions, they are “investments” and the Consumer Price Index does not take them into account.

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