What is Inflation? Theory and Praxis

Consumer price indexes are imperfect indicators of inflation calculated using ad hoc price formulae dierent to the theoretically motivated superlative indexes favored by economists. This paper provides the first estimate of how accurately the CPI predicts inflation. We use the largest price and quantity dataset ever employed in economics to build a Tornqvist inflation index for Japan between 1988 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%) the CPI is a poor predictor of true inflation. Outside this range, the CPI is a much better measure of inflation. We find that the U.S. PCE methodology is superior but still exhibits substantial measurement error and biases.