Many people ask why prices increase year after year while the Reserve Bank says the inflation rate is low. I have heard economists who cast doubt about the merit of inflation targeting citing rising prices as a reason!
I bet that if we conduct a survey we would be surprised to know that most people think the same way.
A layman’s explanation first
This is just an example using arbitrary numbers. Table (1) has four columns. Column 1 has four years, 1 to 4. There is a price level in the second column and the percentage change of the price level, i.e. the inflation rate in the last column.
So in this example the price increased every year from 100 to 102 to 104... The inflation rate, however, remained stable, 2 percent every year. This is what an inflation-targeting central bank desires to achieve.
The sketch below describes it in a different way. A shock at period 1 increases the price from p0 to p1. The price stays there, but the inflation rate, which is the slope (i.e. the change in the price over time), remained unchanged.
Academic talk - not for the average reader
We could go further and use academic language for those who are interested. I tested the data for NZ as everyone in this field does routinely. The price level measured by the CPI has a unit root; inflation does not.
Thus, the forecast of the price level is meaningless because the forecast error variance grows to infinity as the forecast horizon increases. The mean, variance...of the price level are all functions of time.These are the results of targeting the inflation rate. The RB could target the price level if they want to. I have shown that (with Eric Hansen) in 1995 in an RB conference. No takers. Many scholars have written about price level targeting. Still No takers.
As long as the public demand for money (the stock of money, e.g., M1)keeps increasing, which is the case in NZ, the price level will increase in proportion because people spend the money (could be spent on assets and housing too and increase asset prices). Money and prices are highly correlated. Inflation and money growth, however, are not correlated at all because the RBNZ rendered inflation stationary, but not money.I studied this issue in 2001 when I was in the RB https://www.rbnz.govt.nz/research-and-publications/discussion-papers/2001/dp2001-02-2 and I don't think anything has changed since.
If the CPI inflation is under control then What kind of inflation do we have?
Average annual money growth over the past since 1989 is about 7 percent. Lending to housing plus personal lending average growth rate over the period from Dec 1990 is 9.6 percent. People spend the money. They buy things, but they also buy assets and housing. The CPI inflation does not measure that. Hence, inflation is absent.
We have much higher housing price inflation than CPI inflation. Figure (3) plots the two inflation rates. Over the same period from Dec 1990 to Dec 2018, the average CPI inflation was 2 percent while housing price inflation, HPI, was 6.2 percent!