It is no secret that Market Monetarists favour nominal GDP level targeting over inflation target. We do so for a number of reasons, but an important reason is that we believe that the central bank should not react to supply shocks are thereby distort the relative prices in the economy. However, for now the Market Monetarist quest for NGDP targeting has not yet lead any central bank in the world to officially switching to NGDP targeting. Inflation targeting still remains the preferred operational framework for central banks in the developed world and partly also in Emerging Markets.

However, when we talk about inflation targeting it is not given what inflation we are talking about. Now you are probably thinking “what is he talking about? Inflation is inflation”. No, there are a number of different measure of inflation and dependent on what measures of inflation the central bank is targeting it might get to very different conclusions about whether to tighten or ease monetary policy.

Most inflation targeting central banks tend to target inflation measured with some kind of consumer price index (CPI). The Consumer Price Index is a fixed basket prices of goods and services. Crucially CPI also includes prices of imported goods and services. Therefor a negative supply shock in the form of higher import prices will show up directly in higher CPI-inflation. Furthermore, increases in indirect taxes will also push up CPI.

Hence, try to imagine a small very open economy where most of the production of the country is exported and everything that is consumed domestically is imported. In such a economy the central bank will basically have no direct influence on inflation – or at least if the central bank targets headline CPI inflation then it will basically be targeting prices determined in the outside world (and by indirect taxes) rather than domestically.

Contrary to CPI the GDP deflator is a price index of all goods and services produced within the country. This of course is what the central bank can impact directly. Therefore, it could seem somewhat paradoxically that central banks around the world tend to focus on CPI rather than on the GDP deflator. In fact I would argue that many central bankers are not even aware about what is happening to the GDP deflator.

It is not surprising that many central bankers knowingly or unknowingly are ignorant of the developments in the GDP deflator. After all normally the GDP deflator and CPI tend to move more or less in sync so “normally” there are not major difference between inflation measured with CPI and GDP deflator. However, we are not in “normal times”.

The deflationary Czech economy

A very good example of the difference between CPI and the GDP deflator is the Czech economy. This is clearly illustrated in the graph below.

The Czech central bank (CNB) is targeting 2% inflation. As the graph shows both CPI and the GDP deflator grew close to a 2% growth-path from the early 2000s and until crisis hit in 2008. However, since then the two measures have diverged dramatically from each other. The consumer price index has clearly moved above the 2%-trend – among other things due to increases in indirect taxes. On the other hand the GDP deflator has at best been flat and one can even say that it until recently was trending downwards.

Hence, if you as a Czech central banker focus on inflation measured by CPI then you might be alarmed by the rise in CPI well above the 2%-trend. And this has in fact been the case with the CNB’s board, which has remained concerned about inflationary risks all through this crisis as the CNB officially targets CPI inflation.

However, if you instead look at the GDP deflator you would realise that the CNB has had too tight monetary policy. In fact one can easily argue that CNB’s policies have been deflationary and as such it is no surprise that the Czech economy now shows a growth pattern more Japanese in style than a catching-up economy. In that regard it should be noted that the Czech economy certainly cannot be said to be a very leveraged economy. Rather both the public and private debt in the Czech Republic is quite low. Hence, there is certainly no “balance sheet recession” here (I believe that such thing does not really exists…). The Czech economy is not growing because monetary policy is deflationary. The GDP deflator shows that very clearly. Unfortunately the CNB does not focus on the GDP deflator, but rather on CPI.

A easy fix for the Czech economy would therefore be for the CNB to acknowledge that CPI gives a wrong impression of inflationary/deflationary risks in the economy and that the CNB therefore in the future will target inflation measured from the GDP deflator and that it because it has undershot this measure of inflation in the past couple of years it will bring the GDP deflator back to it’s pre-crisis trend. That would necessitate an increase in level of the GDP deflator of 6-7% from the present level. There after the CNB could return to targeting growth rate in the GDP deflator around 2% trend level. This could in my view easily be implemented by announcing the policy and then start to implement it through a policy of buying of foreign currency. Such a policy would in my view be fully in line with the CNB’s 2% inflation target and would in no way jeopardize the long time nominal stability of the Czech economy. Rather it would be the best insurance against the present environment of stagnation turning into a debt and financial crisis.

Obviously I think it would make more sense to focus on targeting the NGDP level, but if the CNB insists on targeting inflation then it at least should focus on targeting an inflation measure it can influence directly. The CNB cannot influence global commodity prices or indirect taxes, but it can influence the price of domestically produced products so that is what it should be aiming at rather than to focus on CPI. It is time to replace CPI with the GDP deflator in it’s inflation target.