Simulations Illustrate Flaw in Inflation Models

This study questions the basic assumption of standard inflation models that there are only two forces driving price changes - underlying inflation and short-term noise. Specifically, the paper analyzes the distributions of individual price changes to shed light on an apparent contradiction: individual price changes are extremely dispersed, while measured inflation, the aggregate of individual price changes, remains relatively steady. Monte Carlo simulations demonstrate that the standard inflation model is inconsistent with this observation. The author reintroduces a new inflation model that explicitly accounts for the possibility of a third price-change driver - long-term sector-specific forces. Simulations show that the new three-forces model corresponds to the data quite well. If standard inflation measures, such as the CPI, are based on an incorrect two-forces model, then Fed policy based on those measures could be misguided. Inflation measures must explicitly account for the possibility that long-term sector-specific forces drive individual price changes.