Why price inflation in developed countries is systematically underestimated

TL;DR

This paper analyzes historical GDP data to suggest that price inflation in developed countries has been systematically underestimated since 1950, leading to significantly lower real GDP estimates and implications for monetary policy.

Contribution

It identifies a structural break in GDP trends around 1950 and proposes that the GDP deflator has been underestimated, affecting economic measurements and policy.

Findings

Significant discrepancy in GDP trends before and after 1950.

Estimated underestimation of the GDP deflator by a factor of 1.4 in the USA.

Implication that the Federal Reserve's interest rate aligns with true inflation when corrected.

Abstract

There is an extensive historical dataset on real GDP per capita prepared by Angus Maddison. This dataset covers the period since 1870 with continuous annual estimates in developed countries. All time series for individual economies have a clear structural break between 1940 and 1950. The behavior before 1940 and after 1950 can be accurately (R2 from 0.7 to 0.99) approximated by linear time trends. The corresponding slopes of regressions lines before and after the break differ by a factor of 4 (Switzerland) to 19 (Spain). We have extrapolated the early trends into the second interval and obtained much lower estimates of real GDP per capita in 2011: from 2.4 (Switzerland) to 5.0 (Japan) times smaller than the current levels. When the current linear trends are extrapolated into the past, they intercept the zero line between 1908 (Switzerland) and 1944 (Japan). There is likely an internal conflict between the estimating procedures before 1940 and after 1950. A reasonable explanation of the discrepancy is that the GDP deflator in developed countries has been highly underestimated since 1950. In the USA, the GDP deflator is underestimated by a factor of 1.4. This is exactly the ratio of the interest rate controlled by the Federal Reserve and the rate of inflation. Hence, the Federal Reserve actually retains its interest rate at the level of true price inflation when corrected for the bias in the GDP deflator.