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Inflation measurement in the age of COVID-19
On the sudden stop in global economic activity this year, Fed Chair Jay Powell said in May 2020 that “the virus is the cause, not the usual suspects.” That started the global process of monetary easing.
Last week at the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming, Powell underlined a critical change in monetary policy strategy, signaling that the Fed will focus on job growth. It will not raise interest rates against oncoming inflation immediately, targeting average inflation instead of annual inflation. Why five years? That’s the announced period for the next monetary policy strategy review.
“It seems like a pretty subtle shift to most normal human beings,” said Janet L. Yellen, the former Fed Chair. As “most of the Fed’s history has revolved around keeping inflation under control. This really does reflect a decisive recognition that we’re in a very different environment,” she said, in an attempt to explain the momentous shift to normal people. Here is my attempt, a fire department that was almost exclusively focusing on putting fires has now said that it will focus on flood rescue. It’s just a different kind of thing to do.
The sudden stop in economic activity was due to a decisive change in the spending habits of consumers. With no vaccine or effective medication, the shift in consumer behavior was almost global. Normalization could be defined as consumers going back to their old consumption baskets, but we are still far from that. The economies have been opening up since last May, yet no sign of consumers going back to their old baskets can be seen. As the saying goes, “You can lead the horse to water, but you cannot make him drink.” Looking for a reason for slower recoveries? It’s the consumers. Why are businesses not investing? It’s the consumers. It’s even obvious in Turkish growth statistics, just have a look at the deeper than average recession in the services and manufacturing industry.
That COVID-19 induced change in spending habits is also visible in job dynamics. I was looking at the recently announced June 2020 employment statistics in Turkey, which showed employment in courier services jumped 26.5 percent from June 2019 to June 2020, while employment in hotels declined by 39.7 percent. To put it mildly, it is an asymmetric recovery process. Are our institutions ready for this? Are they even equipped to see what is happening?
Recently, Alberto Cavallo of Harvard Business School has looked at the impact of COVID-19 on inflation measurement and argued that our current methodology was mostly underestimating the impact COVID-19 has had on the inflation rate. The US consumer price index is definitely understating the inflation rate. Here is an additional reason for Jay Powell to focus on average inflation targeting, if you ask me. The virus is not only putting the brakes on our economies but also distorting our inflation measurement methodology. How?
The shifts in consumer spending habits lead to uneven recoveries in different sectors of the economy. Since the start of the pandemic, consumers have reduced their spending on transportation, hotels, dining out and recreation, and they have spent more on groceries and beverages than they have in past years. Economists couldn’t have known how exactly this would play out, which is why the COVID-19 Consumer Price Index (CPI) diverged from the official CPI. We are still announcing an official CPI as if there is no radical shift in spending habits.
What Cavallo has done in his paper is rather simple. He took the high-frequency US credit and debit card transaction data, assigned new weights to different categories in the consumption basket, and estimates COVID-19 CPI as opposed to the official CPI. He reported April 2020 comparisons for the USA and 16 other countries, including Turkey and France. He found out that in the US and Turkey, for example, COVID-19 CPI is higher than the official CPI, while in France, COVID-19 CPI is lower than the official one. So, when Turkey released new inflation figures this Thursday, it made me think of the Cavallo paper.
With COVID-19, we are indeed in a very different environment. It is true that the major culprit is indeed the virus, rather than “the usual suspects,” but this should not give anyone comfort. This virus assails economic bodies just as it does biological ones. It has many silent symptoms and finds the structurally vulnerable parts of every immune system. That’s the tragedy of Ankara nowadays. We walk around thinking that we can manage the situation, while the virus is working on our weakest points.
But it is unlikely to kill us. Once the pandemic is over, I believe Turkey will have a clear vision of its problems. The choice of a strong structural reforms agenda will be clearer than ever before.