Manipulating inflation.

Today, The Guardian reports that the Chancellor's recent decision to adopt the measure of inflation used in the Eurozone is causing the Bank of England some problems. For example:

As Mr King said, when the switchover occurs in November's pre-Budget report, the Bank will have to explain to the public why inflation, which was above target and falling, is now below target and rising. Threadneedle Street may be forced to print two versions of the inflation forecast, one based on the new measure and one on the old.

All this raises an interesting question. How on earth do we know what the real rate of inflation is?

The Eurozone measure is lower, according to the report, apparently because it excludes housing costs. The retail price index the BoE currently uses also excludes, e.g. wages and stock market prices. In other words neither measure involves a complete survey of prices and both miss out significant factors.

The problem here is that inflation involves a general rise in the prices of goods and services caused when the amount of the currency concerned increases relative to the amount of goods and services being traded. A partial measure of price rises will not produce an accurate picture -- prices of some products may rise whilst others fall. Indeed if the supply of currency remains static, then a price rise in one sector of the economy will be balanced by a fall in prices elsewhere. The govt statistics give a distorted picture of this. And isn't it convenient for the Chancellor that the adopting the new measure of inflation will suddenly see Britain meeting it's inflation targets again?

(See this document for a deeper discussion of inflation.)