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Measuring inflation in the UK and euro area – BCA Research

As the price index of all goods and services produced within the country, the GDP deflator is the truest measure of domestically sourced inflation (or deflation), according to BCA Research.

The Bank of England and the ECB – like most inflation targeting central banks – use the CPI to measure price inflation. But by definition, the CPI only includes the prices of goods and services purchased by consumers. This measure ignores prices in roughly 35% of the economy that is comprised of government spending, capital spending by firms, and goods and services made for export. A broader gauge of inflationary pressures is the GDP deflator.

When the CPI and the GDP deflator are giving the same message, there is no harm in choosing the CPI as the inflation target. Indeed, it has some advantages: the CPI is calculated monthly with short reporting lag times. In contrast, the GDP deflator is calculated quarterly, with some delay, and is then subject to revisions. Hence, the CPI is a much more user-friendly inflation index.

But when the CPI consistently clashes with the GDP deflator, policymakers must give precedence to the deflator. And intentionally or not, this is exactly what the BoE has done. Its QE programs over the past three years look incongruous with the CPI’s overshoot, but are completely consistent with the GDP deflator’s undershoot.

Bottom line: In both the UK and the euro area economies, the broadest measure of prices – the GDP deflator – clearly shows deflationary risks exceed inflationary risks: both the BoE and ECB have an economic justification for further monetary easing. 

This post was originally published by the BCA Research blog.

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