Whose Inflation? Which Price Index?

Scott Sumner mentioned the other day I slight disagreement between the two of us over whether monetary policy was generally too tight during the “great moderation” period or if things just happened to go awry in 2008. I have a couple of reasons for my view, but one of them that I think he might find persuasive is illustrated by this chart showing the evolution of two different price indexes since the trough of the Volcker Recession.

The faster-growing one is the personal consumption expenditures deflator which seeks to measure the price paid for stuff that households buy. The slower-growing one is the GDP deflator which seeks to measure the price of stuff in general, including investment goods and production inputs for exports. The Fed, like most central banks, targets consumer price inflation but if it’s going to do inflation targeting it ought to target the GDP deflator. Basically central banks have meandered into a confusion between what kind of inflation annoys people (consumer price inflation) and what kind of inflation is relevant to monetary policy and output (overall price inflation). Now at times the GDP deflator runs hotter than the PCE deflator and at times it runs cooler, but during the period of the Great Moderation it’s generally increased at a slower pace than the PCE deflator. So PCE targeting has in the aggregate led to slightly tighter money than we should have had. The divergence between these price indexes accounts for about a third of the wedge between productivity growth and median compensation.

But what pulls this together into a grand unified theory is that for the vast majority of the Great Moderation the deflator gap was very modest. The exception came in 2008, when for a little while consumer prices rose much more rapidly than production prices. The rapid growth in the divergence helps explain why the Fed’s stance rather suddenly became dramatically too tight which, in turn, is a big part of the reason why a modestly painful decline in house prices and construction activity transformed into a huge catastrophe.