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Monday, July 07, 2003

What a Difference an Index Makes

Some months ago Brad asked me about how the HICP (the harmonised price index) was determined, and I answered something to the effect that: with difficulty. This difficulty precisely arises from the lack of harmony in methodology used in determining price values in the different countries. So we have something like an average derived from 6 apples, 5 pears, and 8 pinneapples: not as illuminating as it should be for the importance that has been placed on this number. But there is another dimension to HICP, and that is what is included and what is excluded in the index. This becomes important since the UK still uses its old RPIX, and this gives a different reading to the HICP when applied to the UK, not because of methodologies, but because of composition questions. The RPIX was running at 2.9% for the year to May (ie no big deflation scare) while the HICP came in at 1.2% (and with interest rates at 3.75%, ie deflation risk and tight monetary conditions). The principle difference here is in the inclusion of house price depreciation linked to housing prices and local taxes in the RPIX. Without housing the RPIX would be running at around 1.8%. As MS's Joachim Fels & Melanie Baker inform us:

The remaining gap of some 0.5 percentage point between HICP and RPIX inflation is explained mainly by the way in which raw prices for individual goods and services are aggregated at the micro level. The RPIX uses simple averages to combine prices, while the HICP uses a geometric average to combine the same prices, with the latter method producing lower inflation rates than the former. In its May Inflation Report, the Bank of England estimated that this had accounted for an average divergence of around 0.5 percentage point between the two inflation measures, mostly concentrated in clothing and footwear and household goods. Thus, once the differences in coverage (housing costs) and aggregation methods are taken into account, RPIX and HICP inflation rates are virtually the same.

Complicated isn't it? The issue is given added piquance by Gordon Brown's June 9th announcement of his intention to change the Bank of England's remit from targeting RPIX inflation to targeting HICP inflation in November. Apart from the detail that by November house prices may be falling in the UK, this does raise the question of what measure we have of deflation? On some measures the German economy may already be in deflation, but how do we really know. I would say here that the behavioural indicators may well be the best ones. Deflation is problematic since it induces certain patterns of behaviour and expectations in individuals and enterprises. When we can observe those patterns of activity, and identify the relevant expectations (look at Japan's 30 year interest rates for eg) then I think we can say that deflation has arrived. What preoccupies me is that it is precicesly this behavioural and expectational shift which may be occuring right now in Germany.

When it comes to assessing which countries are most likely to enter deflation territory, the UK is hardly ever mentioned. Rightly so, you may say. Consumer prices as measured by the RPIX increased by 2.9% in the year to May and the GDP deflator was up 2.7% on the year in 1Q. Polls such as the quarterly NOP survey on public attitudes to inflation conducted for the Bank of England (BoE) show that the public expects inflation to be around 2.5% in a year's time -- the highest expected rate since the survey started in 1999. Similarly, long-term inflation expectations in the bond market, as measured by the difference between nominal gilt yields and the real yield on index-linked gilts, are hovering around the same level. Annual house price inflation, while slowing, is still running at close to 20%, and the depreciation of sterling against the euro is mitigating the impact of global deflationary pressures on import prices. If push comes to shove, UK economic policy would still have ample room for manoeuvre to respond to deflationary shocks.

The story would have ended here if it weren't for that strange European creature called the HICP -- the Harmonized Index of Consumer Prices -- which is a measure of average prices produced by all EU countries according to a common methodology and used by the ECB to target price stability. On this gauge, UK consumer price inflation plunged to only 1.2%Y in May, the latest available month of data. Thus, current harmonised inflation in the UK is, and has been for a long time, well below the current euro-area-wide 2.0% inflation rate and is only marginally higher than Germany's harmonised 1.0% rate for June. So, if Germany is already in or at least close to deflation, as most pundits claim, the UK appears to be fairly close to the deflation danger zone too, according to the HICP gauge.

Source: Morgan Stanley Global Economic Forum

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