Inflation-targeting, CPI measures and the poor

In a bid to get back to regular blogging, below is a comment that I've just left under a Daily Maverick column by Paul Berkowitz, entitled "Who benefits from inflation-targeting?" It includes the following provocative graph on the relative inflation levels faced by different consumer groups in South Africa.

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There are a number of legitimate reasons to critique an inflation-targeting regime. Further, the relatively high inflation burden felt by poorer segments of society certainly merits attention in of itself. That said, there are some persistent misconceptions among the public about inflation-targeting: What are its goals and what are the (theoretical) mechanisms by which these are achieved -- particularly w.r.t. a central bank's chosen CPI measure? My gripe with this article is that it may perpetuate such misconceptions by failing to acknowledge an important principle of inflation-targeting.

Rather than simply being an end in of itself, an inflation target is also seen as a means of stabilising the output gap (and ultimately smoothing of the business cycle). Theoretical justification for this so-call "divine coincidence" -- which implies no trade-off between the twin goals of stabilising inflation and maintaining optimal economic output -- is derived from the standard new Keynesian DSGE models favoured by a large segment of macroeconomists. See Blanchard and Gali (2005), or as Blanchard has written elsewhere:

This is a really important result. It implies that central banks should indeed focus just on inflation, and can sleep well at night. If they succeed in stabilizing inflation, they will automatically generate the optimal level of activity. (p. 3)

The upshot is that, if we are going to criticize the representativeness of headline CPI for all income groups, then we should at least acknowledge it's (intended) wider role in stabilising the output gap. (The CPI basket is chosen, after all, because it corresponds to average purchases within the economy as a whole.) You can certainly argue about the conditions under which "the divine coincidence" is satisfied, as well the theoretical underpinnings of the DSGE models. However, closing the output gap is probably very much in the poor's interest as well.

On a final and related note, there are severe drawbacks to the SARB targeting a predominantly commodities-based basket that would more closely accord with the average purchases of low-income families. Most obviously, the SARB is more or less powerless to control the inherent volatility of commodity groups, not to mention the potential for causing very counterproductive amplifications in the consumption cycle. (See here, esp. end of point 4.)

Personal note

I'm not normally one for broadcasting personal information and relationship updates on social media, but, hey, this a big one.

Very pleased, then, to say that I am recently returned from a trip to Veneto, Italy, engaged to the beautiful Miss LB. (Soon to be Mrs LM, although a rose by any other name...)

My five-year charm offensive has obviously paid dividends. 

Finally. 

In other news, Daniel Kuehn was kind enough to remind me on Facebook that I shouldn't make the mistake of thinking that my probation period is now over... Sage advice.

Music updates

My latest contributions to Noondaytune are a mix of classic rock and Nordic lo-fi (complete with a youth choir). Something for everyone!

1) Crosby, Stills, Nash & Young - "Almost Cut My Hair"

2) Mr Little Jeans - "Oh Sailor"

It's not every day that you're called an idiot by Nassim Taleb

Or a "bloggist" for that matter.

Here and here.

To be fair, Taleb has charged that many minds superior to my own are beset by idiocy, so I'm in reasonable company. More seriously, he did at least tone down his bombast when I pointed out that he had misunderstood what I was asking.

The background is this post, where I wondered (quite respectful like!) what Taleb made of the research that shows people have a tendency to overestimate the likelihood of low-probability events if they were framed in highly dramatic terms. This seemed to run counter to a recurring theme in his writings, which is that people are blind to "black swans"... basically that they consistently underestimate low-prob, high impact events.

Taleb pointed me towards a short paper on "binary" (up vs down) versus "vanilla" (+500 vs +5,000,000 vs -5,000,000) outcomes, which was supposed to refute the relevance of such studies. However, I remain rather unconvinced. Consider the key figure in my previous post:

Perceived versus actual fatalities. Adapted from Lichtenstein et al. (1978).

As I wrote back then: What we see here is that people have a clear tendency to overstate -- by an order of several magnitudes -- the relative likelihood of death arising due to "unusual and sensational" causes (tornadoes, floods, etc). The opposite is true for more mundane causes of death like degenerative disease (diabetes, stomach cancer, etc).

Now, I certainly agree with Taleb that it is important to distinguish between between binary and continuous outcomes. Asking whether a stock will go up/down is a much less interesting (and less complex) question to ask than whether it will go up/down by a certain amount. You are clearly not comparing apples with apples if you say that a stock will go up by 5% or 500%. In short, binary and continuous ("vanilla") outcomes are incommensurable in terms of evaluating payoffs.

However, the studies that I linked to are interesting exactly because they are comparing the *same* outcome (i.e. death). It makes no sense to say that death by tornado equals five times death by stroke. They are obviously equivalent. The "payoff" is thus the same because the outcome is the same. Further, I'm not claiming that the insights from these particular studies are fully generalisable to all other low probability, high-impact outcomes (especially those in finance). Yet they do show that underestimation of black swan events is hardly a universal phenomenon either... In fact, people here are shown to rely on heuristics that lead them to a diametrically opposite conclusion! I was ultimately interested in hearing from Taleb whether he thinks these heuristics are efficient or not. I didn't get an answer unfortunately, so I guess we'll have to judge for ourselves.

A final observation is that I disagree with the paper's assertion that "binary is limited to probability". (In other words, that binary outcomes say nothing about the size of a payoff.) This is certainly true in many cases -- again, especially in finance -- but not always. In some instances, binary outcomes imply payoffs directly. The obvious example is the one that we have been discussing in this very post, i.e. death. Indeed, I would think that Taleb probably agrees with me, given that one of his favourite analogies is that of a turkey being fattened up in preparation for Thanksgiving.

What Taleb calls his "classical metaphor". A turkey on his way to becoming dinner. (Source)

With apologies to Monty Python, you might say that the prospect of becoming an ex-turkey implies a very obvious payoff indeed.

UPDATE: Andrei Shleifer agrees.