When it comes to inflation, I agree with Lord Kelvin. From a lecture the British physicist delivered at the Institute of Civil Engineers on May 3, 1883: “I often say that when you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot measure it, when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind; it may be the beginning of knowledge, but you have scarcely, in your thoughts, advanced to the stage of science, whatever the matter may be.”
At present, the world’s highest inflation rate is in Venezuela, where the annual rate is 15,657%. Venezuela’s bout of hyperinflation began on November 13, 2016, when the monthly inflation rate first breached the 50% per month hyperinflation threshold. Today, Venezuela’s monthly inflation rate stands at 167%. So, Venezuela is a member of the rouges’ gallery of hyperinflation episodes, of which there have only been 58 in recorded history. The chart below paints the picture of Venezuela’s hyperinflation calamity.
The inflation rates in the chart above are measured by The Johns Hopkins-Cato Institute Troubled Currencies Project (TCP), which I direct. In 2013, after the Banco Central de Venezuela (BCV) stopped reporting inflation statistics on a regular basis, we began measuring Venezuela’s inflation. We employ high-frequency data that allow for the daily measurements of both monthly and annual inflation rates. We measure. We do not forecast. Indeed, forecasting in a hyperinflationary setting is a mug’s game.
How do we measure? The most important price in an economy is the exchange rate between the local currency – in this case, the bolivar – and the world’s reserve currency, the U.S. dollar. As long as there is an active black market (read: free market) for currency and the data are available, changes in the black market exchange rate can be reliably transformed into accurate measurements of countrywide inflation rates. The economic principle of purchasing power parity (PPP) allows for this transformation. And the application of PPP to measure elevated inflation rates is rather simple.
During periods of elevated inflation, PPP is the proper theory to use for measurement. Indeed, PPP holds during episodes of hyperinflation, and it holds very tightly. So, with Nobel Prize-winner Tjalling Koopmans’s admonishment to economists in mind, we are measuring, and we are measuring with the correct theory.
Beyond the theory of PPP, the intuition of why PPP represents the ‘gold standard’ for measuring inflation during hyperinflation episodes is clear. All items in an economy that is hyperinflating are either priced in a stable foreign currency (the U.S. dollar) or a local currency (the bolivar). If they are bolivar prices, they are determined by referring to the dollar prices of goods, and then converting them to local bolivar prices after checking with the spot black-market exchange rate. Indeed, when the price level is increasing rapidly and erratically on a day-by-day, hour-by-hour, or even minute-by-minute basis, exchange rate quotations are the only source of information on how fast inflation is actually proceeding. That is why PPP holds and why we can use high-frequency (daily) data to calculate Venezuela’s inflation rate.
So much for the way things should be measured correctly. With that in mind, let’s take a look at the International Monetary Fund’s (IMF) treatment of Venezuela’s inflation. We conduct this analysis not only because the IMF is the premier international body that deals with the monetary matters of its 189 member countries, but also because whatever the IMF utters is treated by the financial press as gospel. In consequence, IMF data are widely reported and drive public opinion.
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