The European approach
The harmonized index of consumer prices is one of the most important indicators produced by Eurostat. The HICP, which is available monthly, is an internationally comparable measure of inflation calculated by each Member State using a specific formula. Since January 1999, the European Central Bank (ECB) has used the HICP as its target measure of inflation and one of its two pillars of monetary policy (the second is money supply).

Each Member State has its own HICP, and at the European level there are aggregate indexes with different geographical coverage. For example, the Monetary Union Index of Consumer Prices includes data only from the eurozone countries. The European Economic Area Index of Consumer Prices has the widest coverage of all Member States and includes Iceland and Norway. The European Index of Consumer Prices measures the annual inflation in the EU. However, the key market-moving inflation measure is the HICP for EMU members only. It should be noted that all of the countries maintain their national CPI for domestic purposes. Many cost-of-living adjustments and union contracts are pegged to these national indexes. In the United Kingdom, for example, the CPI as calculated using HICP methodology is used solely for monetary policy purposes.

To date, the Europeans have not been able to agree on how to measure owner-occupied housing costs. Consequently, they have simply ruled all owner expenses (except for minor repairs and maintenance) entirely out of the scope of the HICP.

The U.S. approach - hurdles to overcome
In the May 2006 issue of the Monthly Labor Review an article entitled Comparing U.S. and European Inflation: the CPI and the HICP by Walter Lane and Mary Lynn Schmidt introduced readers to an experimental consumer price index that follows, as closely as possible, Eurostat's methodology. The harmonized index of consumer prices differs in scope and coverage from the consumer price index. For example, the U.S. CPI covers only urban areas, while the HICP includes rural areas as well. But most importantly, the U.S. CPI includes owner-occupied housing (which carries an impressive weight of 23.4 percent in the index). The HICP excludes owner-occupied housing in part because methods for measuring price changes for owner occupied housing are controversial and difficult and because it is omitted from the European index. But before the new index could be constructed, the CPI first was expanded to cover the entire (non-institutional) population and then was narrowed to remove the owner-occupied housing costs that the HICP excludes from its scope.

The Consumer Price Index for All Urban Consumers or CPI-U estimates price change for the non-institutional urban population, and many steps had to be taken before an HICP could be developed. The CPI-U excludes the rural, non-metropolitan population from coverage due largely to the difficulty involved in sampling remote and sparsely populated areas of the country. The European HICP estimates price change for the entire population, urban and rural. Before a HICP could be constructed for the U.S., an experimental CPI for the total U.S. population was created.

Once an index for the total U.S. population was derived, its item coverage had to be adjusted so that it corresponded to that of the European index. Again, the major difference between the U.S. and European indexes is in the treatment of owner-occupied housing costs, a difficult and controversial part of any CPI. Most economists agree that a house (or any other type of housing unit) is a capital good and not a consumer good. Thus, expenditures to purchase or make major improvements to houses are investments and out of the scope of a CPI. Of course, on the one hand, homes provide the occupant with shelter, a valuable service that owner occupants would have to pay for if they did not own their homes; on the other hand, because they live in their homes instead of renting them out, owner occupants are foregoing income they could receive. To capture these countervailing ideas, the U.S. CPI uses a "rental equivalence" approach that estimates the changes in what owner occupants would pay to rent equivalent housing. Some European countries use this approach in their national CPI's as well. Others use a variety of methods that usually include mortgage interest and taxes.

Comparing U.S. and European inflation
Each European country produces its own national HICP. Eurostat combines national HICP's to produce HICP's for multinational groups. A country's weight is its share (within the multinational group) of private domestic consumption expenditures - a component of a country's gross domestic product.

The chief sources of greater measured inflation in the United States are motor fuels, gasoline, and medical services and drugs. All of these U.S. indexes have higher weights, and all exhibit greater price increases, than their European counterparts. Offsetting this relationship a bit, tobacco and alcohol rose more rapidly in the European index and have more weight there as well.

The U.S. CPI uses a geometric formula for most elementary aggregates, whereas many European countries choose an arithmetic formula, which tends to rise more rapidly. (HICP rules allow either formula.) The U.S. CPI also may make quality adjustments for changes in consumer products and may introduce some kinds of insurance differently. For example, in Europe they use a premiums net-of-claims-paid approach; by contrast, the U.S. CPI uses gross premiums for household and vehicle insurance.

Future versions of the U.S. HICP may be able to adopt additional measures which would allow that index to follow the European methodology more closely. Even when identical methodology is used, important differentials in societies can impact the indexes. For example, because Americans pay for a much larger portion of their medical care expenses, medical care has a much larger importance in the U.S. indexes. By contrast, Europeans generally receive much of their medical care through government programs, which are out of the scope of both CPI's and HICP's.

Bottom Line
International comparability got a boost when the European Union and then the European Central Bank were formed. It was now essential to be able to compare member economic performance so that appropriate policy could be put in place. This is especially true in the ECB's monetary policy deliberations. Inflation is one of the Bank's two monetary policy pillars and without an appropriate price measure, policy could not be made.

Inflation measures are a market moving indicator as investors focus on central bank policies and especially those that target price movements. An addition to analysts' arsenal of data is surely welcome. But there is still a long way to go before true international comparability is a reality.