Core Problem

But the central bank says a 'core' inflation number is in single digits, and it was "successful" in containing underlying inflation.

"Accordingly, the core inflation calculated on the basis of New Colombo Consumer’s Price Index (CCPI(N)) shows an inflation of only 8 per cent on a point to point basis and annual average inflation of 7.5 per cent in 2007," the Central Bank said in a statement.

"Accordingly, demand management polices of the Central Bank have been successful in containing the underlying inflation well below 10 per cent throughout the year. This trend has continued so far in 2008 as well."

So-called 'core inflation' in many countries and especially in the United States, has come under strong fire from critics as having no connection to living human beings because they drop vital components such as food and energy.

This, critics point out, makes 'core' inflation a meaningless concept.

"The inflation arising from changes in food and energy prices are volatile and often subject to temporary fluctuations caused by supply shocks, mostly driven by weather disturbances or external shocks, and changes in administered prices or tax policies which are beyond the control of the monetary authority," the Central Bank said in a statement.

"Monetary authorities all over the world take their monetary policy decisions on the basis of the underlying trend in inflation which is derived by removing volatile components in a consumer price index.

"The underlying trend in inflation is known as core inflation," the central bank said.

In June 2007 The Economist magazine facetiously described the US core index as the "cold and hungry index" and asked whether the typical American was "on a permanent fast, walks everywhere and survives without heating or air conditioning."

This was shortly after the Bank of England Governor Mervyn King called core inflation without food and energy "highly misleading."

In the US, 'core' inflation now consists largely of 'imputed rent' which is not even real market rents, making it even more removed from the inflation that ordinary people feel than some of the 'core' indices used in other countries.

US authorities in particular are now coming under increasing fire not only for the use of 'core inflation' and lulling the public into a sense of complacency and then driving the country and also the world into a housing, credit and commodity bubble, but also for manipulating the entire 'headline' consumer index.

Government Statistics

"There is also concern that the data that we are observing is not the actual data in the US," Howard Nicholas, an economics lecturer at the Institute of Social Studies in The Hague, told a forum organized by the Citibank in Colombo last week.

"The starting point is that the inflation figures for the last 15 years have been adulterated in the US - the consumer inflation figure."

Nicholas says one of the sources that is now gaining much attention is a website called Shadow Government Statistics.

Critics say the starting point in US inflation index manipulation was when house prices were replaced with rents. House prices go up when monetary policy is loose (when the central bank prints) but rents usually take longer to show up in a price index.

In the early 1980's the US started using 'imputed house owner' rents, which were not actual market rates.

This keeps an asset price inflation bubble out of the index, sending misleading signals to a country's central bank which will continue to print money as if there was no 'inflation'.

In the late 1990's a commission headed by economist Michael Boskin, and supported by former US Fed chief Alan Greenspan came up with new ways to understate inflation.

These techniques include the use of 'hedonic regression' which discounts price increases of a good or service on the pretext that it gives more 'pleasure' to users.

Other methods of manipulating indices include the use of 'substitution' which assumes that people will move into cheaper alternatives when some goods go up in price.

By constantly changing the basket, 'substitution' violates the most basic principle of index construction, which says a market basket should be fixed.

Bubble Creation

Nicholas's comments came as authorities were coming under fire for constructing the CCPI-N index by dropping an entire expenditure group out of it.

The statistics office also suppressed a country-wide index after it shot up to 26.2 percent in November 2007.

But now an older index which has higher components of food in it has overtaken it by rocketing to 28.1 percent.

One of the advantages of understating inflation is that it will allow governments to overstate gross domestic product (GDP) growth.

Shadow Governments Statistics was started by a consultant who was hired by an airline to find why its passenger forecast software based on economic growth was no longer working.

While such statistics give comfort to authorities it has dangerous repercussions for ordinary people and also for monetary policy, which tends to be loose until an entire financial system collapses as has happened in the United States.

"Actually the GDP figures for the US are much lower than they show," Nicholas said.

"If we look at the period from 2001 to 2008 according to the alternative figures, there is only one year of economic growth in the US. That year is 2005. All the other years are negative. That is why you get this credit bubble."

In Sri Lanka the new consumer price index has come under fire for understating inflation and also its potential to overstate GDP numbers.

In the US, banks lent to people because house prices started to go up. Increased lending at low rates caused the houses to go up again in value, allowing house-owners to get a second mortgage.

Such bubbles are not sustainable and eventually burst and come down to earth, as has happened now.

"It is not a sub-prime problem. It is not a US problem. We can see the bubble bursting. People are running away from risk," observes Nicholas.

Reality or Fiction?

About a third of the US price index is now related to housing, though it has little connection to actual costs.

Critics point out that one of the ironies of the current monetary environment in the United States is that the price index may now be over-stating inflation rather than under-stating it.

This is because with a large portion of the consumer price index (and a larger portion of the 'core' index) being composed of imputed rents it is not reflecting the steep falls in house prices that the US is now experiencing.

Because 'imputed rents' are removed from reality they do not fall with real house prices.

Britain which has an inflation targeting regime uses mortgage payments in its RPI index. Mortgage payments are far more responsive to actual house prices. This allows a central bank to nip an asset bubble in the bud soon after it starts.

Inflation targeting limits the level of inflation a central bank can create to about 2-3 percent by law. This forces the central bank to keep prices low at the expense of other objectives.

But central banks have created such bubbles, time and time again, throughout monetary history and got banks into trouble by creating asset-price and commodity bubbles, with the US Fed being a prime culprit.

US money printing has also fired a global commodity bubble with oil zooming above 100 US dollar a barrel and gold above 1000 dollars.

Wheat, rice and other foods are also going up as the US dollar falls due to money printing by the Fed which is desperate to save the country's financial system from collapse.

Sri Lanka's central bank says global inflation and also inflation in the island is driven by increased demand for consumer goods and oil by emerging economies like China and India.

Bad weather has also created global shortages of agricultural commodities. The Central Bank says "shortages" are also created in world markets by the diversion of cereals and edible oil crops towards bio-fuel.

However others say it is the result of a commodity bubble which is yet to burst, fired by US money printing where all kinds of commodities ranging from food to minerals to precious metals are trying to settle at a new level.