How Much Do Official Price Indexes Tell Us about Inflation?
Official price indexes, such as the CPI, are imperfect indicators of inflation calculated using ad hoc price formulae different from the theoretically well-founded inflation indexes favored by economists. This paper provides the first estimate of how accurately the CPI informs us about "true" inflation. We use the largest price and quantity dataset ever employed in economics to build a Törnqvist inflation index for Japan between 1989 and 2010. Our comparison of this true inflation index with the CPI indicates that the CPI bias is not constant but depends on the level of inflation. We show the informativeness of the CPI rises with inflation. When measured inflation is low (less than 2.4% per year) the CPI is a poor predictor of true inflation even over 12-month periods. Outside this range, the CPI is a much better measure of inflation. We find that the U.S. PCE Deflator methodology is superior to the Japanese CPI methodology but still exhibits substantial measurement error and biases rendering it a problematic predictor of inflation in low inflation regimes as well.
The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. We would like to thank Morgan Hardy, Scott Marchi, and Molly Schnell for excellent research support. We also would like to thank Sakai Ando, Kosuke Aoki, John Greenlees, and Emi Nakamura for excellent comments. David Weinstein would like to thank the National Science Foundation (SES-11227493) and the Center on Japanese Economy and Business for generous financial support. Jessie Handbury would like to thank the Research Sponsors' Program of the Zell-Lurie Real Estate Center at Wharton for financial support. Tsutomu Watanabe would like to thank the Japan Society for the Promotion of Science for financial support (JSPS Grant-in-Aid for Scientific Research no. 24223003).