Why Do We Use Core Inflation?

There is a lot of confusion over the Fed's use of core inflation as part of its policy making process. One reason for confusion is that we using a single measure to summarize three different definitions of the term "core inflation" based upon how it is used.

First, core inflation is used to forecast future inflation. For example, this recent paper uses a "bivariate integrated moving average ... model ... that fits the data on inflation very well," and finds that the long-run trend rate of inflation "is best gauged by focusing solely on prices excluding food and energy prices." That is, this paper finds that predictions of future inflation based upon core measures are more accurate than predictions based upon total inflation.

Second, we also use the core inflation rate to measure the current trend inflation rate. Because the inflation rate we observe contains both permanent and transitory components, the precise long-run inflation rate that consumers face going forward is not observed directly, it must be estimated. When food and energy are removed to obtain a core measure, the idea is to strip away the short-run movements thereby giving a better picture of the core or long-run inflation rate faced by households. I should note, however that this is not the only nor the best way to extract the trend and the Fed also looks at other measures of the trend inflation rate that have better statistical properties. Thus while the first use of core inflation was for forecasting future inflation rates, this use of core inflation attempts to find today's trend inflation rate [There is a way to combine the first and second uses into a single conceptual framework that encompasses both, but it seemed more intuitive to keep them separate. In both cases, the idea is to find the inflation rate that consumers are likely to face in the future.]

Let me emphasize one thing. If the question is "what is today's inflation rate," the total inflation rate is the best measure. It's intended to measure the cost of living and there's no reason at all to strip anything out. It's only when we ask different questions that different measures are used.

Third, and this is the function that is ignored most often in discussions of core inflation, but to me it is the most important of the three, it is the inflation target that best stabilizes the economy (i.e. best reduces the variation in output and employment).

In theoretical models used to study monetary policy, the procedure for setting the policy rule is to find the monetary policy rule that maximizes household welfare (by minimizing variation in variables such as output, consumption, and employment). The rule will vary by model, but it usually involves a measure of output and a measure of prices, and those measures can be in levels, rates of change, or both depending upon the particular model being examined, but generally a Taylor rule type framework comes out of this process ( i.e. a rule that links the federal funds rate to measures of output and prices).

However, in the Taylor rule, the best measure of prices is usually something that looks like a core measure of inflation. Essentially, when prices are sticky, which is the most common assumption driving the interaction between policy and movements in real variables in these models, it's best to target an index that gives most of the weight to the stickiest prices (here's an explanation as to why from a post that echoes the themes here).  That is, volatile prices such as food and energy are essentially tossed out of the index.

Another feature is that the indexes often include both output and input prices, and occasionally asset prices as well. That is, a core measure of inflation composed of just output prices isn't the best thing for policymakers to target, a more general core inflation rate combining both input and output prices works better.

The core inflation rate you see in the news, the one that strips out food and energy, should be though of as a short-hand, quick measure of all three of these concepts. But in each case the Fed uses measures (formally or informally) designed to best satisfy these three functions. For example, when it forecasts future inflation, it uses a different concept of core inflation than it uses in setting policy.

The Fed paper linked above is one example of how the Fed searches for the optimal way to predict future inflation. All that matters for policy is finding the most accurate way to predict inflation, and they will use whatever definition of inflation is best suite for this job. There is evidence that core inflation is best and that's why it is used, but it is a statistical question and didn't have to come out that way (and the best measure of core inflation may not be simply stripping out food and energy - also, there are different measures of prices to choose from, e.g. the CPI and the PCE).

When it comes to setting policy, the Fed doesn't formally use a Taylor rule, though they certainly have Taylor rule estimates in the information they use when considering policy moves, instead they look at a variety of measures of inflation (both core and total), and they look at the rate of change in input prices such as wages and commodities (e.g. oil) as well. They then weight each of those pieces of information in some way (and hence construct an implicit index of all of this information), and then set the federal funds rate accordingly. While I have no way of knowing if the weights they use are optimal, this is exactly what the theoretical models say they should do. But the point is that it is some implicit combination of all of this information that matters for policy, and hence this core measure is very different from the core measure that is best at predicting future inflation alone.

The core inflation rate you see in the news, the CPI less food and energy, does do a fairly good job of representing the information the Fed uses to forecast future inflation, i.e. it is a measure of the trend rate of inflation (but not the best one), and it also does well at approximating the information the Fed will use to set policy, but the actual process it uses is more complicated than this and the Fed employs measures that are specialized for the job at hand.

Finally, there is also a question of what we mean by inflation conceptually. Does a change in relative prices, e.g. from a large increase in energy costs, that raises the cost of living substantially count as inflation, or do we require the changes to be common across all prices as would occur when the money supply is increased? Which is better for measuring the cost of living? Which is a better target for stabilizing the economy? The answers may not be the same. For a nice discussion of this topic, see this speech given yesterday by Dennis Lockhart, President of the Atlanta Fed:

Inflation Beyond the Headlines, by Dennis P. Lockhart, President, Federal Reserve Bank of Atlanta: ...Let me begin by posing the simple question: What do we mean by "inflation"? The answer to that simple question isn't as simple as it may seem.

The popular treatment of inflation in our sound bite society risks confusing inflation with relative price movements and the cost of living. By cost of living, I'm referring to the costs you and I incur to maintain our level of consumption of various goods and services including essential items such as food, gasoline, and lodging. 

Relative price movements occur continuously in an economy as individual prices react to market forces affecting that good or service. Neither relative price movements nor sustained high living costs constitute inflation as economists commonly use the term....

And I think I'll end with this part of his remarks:

Attempts to measure the aggregate rate of price change—no matter how sophisticated—remain imperfect. As a result, when it comes to measuring inflation, judgment is needed to distinguish persistent price movements that underlie overall inflation from the relative price adjustments. Separating the inflation signal from noise involves much uncertainty—especially when making decisions in real time. Discerning accurately the underlying trend is difficult. It is essential for those of us who have responsibility for responding to these trends to use a wide variety of core measures and inflation projections to make the most informed judgment we can.

Comments

[Cost Benefit Analysis is Incomplete]

"...the inflation target that best stabilizes the economy (i.e. best reduces the variation in output and employment)..."

Does large scale redistribution of resources via distributing new money creation to a few really maximize the median welfare? Output may be a bit more stable, but the median family now has to work far more hours to make ends meet. Retirees are sinking into the abyss, becoming totally dependent upon inadequate Social Security as their corporate pensions/401ks lose ground to inflation. National savings have all but disappeared, as savers fled to inflation hedges (homes), making us totally dependent upon importing foreign savings.

The benefits are constantly trumpeted, but the costs are rarely given much thought. Welfare consists of more than stable output. What about the terrible cost of the current system? Dual mandates are not worth the cost. There are far more effective/less expensive unemployment programs possible than using the blunt instrument of monetary policy.

[Mark Thoma]

The welfare function maximizes utility, so monetary policy is just trying to do whatever makes you happy. Some of you are hard to please though.

In the models, if distribution is different than according to, say, changes in productivity, then welfare will fall since there will be a distortion in the model (and things like more hours are a variation in employment which is also in the model). Since that is the charge in recent years - that wages have not matched productivity - yes, the models would see this as a deviation from optimum and react to try to correct it, at least to the extent that it can. [SS is indexed for inflation, most payments are now, so that charge, while once true long ago, no longer holds - and yes, I know about the measurement questions.]

The best thing is to use both types of policy in combination, not one or the other exclusively as you've suggested. A single mandate of inflation ignores employment, that's not good, and a single mandate of output ignores inflation. Since there is both empirical and theoretical evidence that variations in both harm all the things you say you care about, I am going to stick with the dual mandate approach, that is the best way we know of to attain the goals you've implicitly embraced.

[robertdfeinman]

Mark Thoma:
This would be an excellent entry for a new section - an FAQ.

Like the old joke about the prisoners just using numbers instead of the actual jokes because everyone has heard them so often, being able to point people to the appropriate answer could cut short much repetitive discussion as new people visit.

Other candidates could include some stats on social security, budget trends, changes in the standard of living, the role and organization of the Fed and whatever econ 101 concepts you think are widely misunderstood.

It's a pity to see well thought out postings get pushed down memory hole.

[bakho]

For a number of reasons, the Philips curve fails to be predictive (Stagflation for instance). This means that the model is missing one or more important components that would improve predictability, at least in some instances.

In our current situation, monetary policy is more flexible and can react more quickly than fiscal policy. However, absent a substantial focus on regulation, monetary policy serves as a broad general economic corrective and not one that can target specific sectors of the economy that are out of balance.

The current anti-regulatory, anti-fiscal solutions (unregulated ("free") market and privatization of public services) have failed to solve fundamental problems with our economy. Bubbles result from the lack of appropriate regulations to moderate boom bust cycles. Monetary policy alone cannot address bubbles in specific sectors without harming other parts of the economy. Monetary policy needs to complement fiscal and regulatory policy, not be promoted as THE solution to all economic problems.

Our current problems are less the result of bad monetary policies as bad fiscal and regulatory policies. Unfortunately for monetary policy, bad fiscal and regulatory policy can create an economic environment where monetary policy is helpless. This is where we are today. Monetary policy can make matters slightly better or a lot worse, but truly fixing our problems requires a renewed focus on fiscal and regulatory policy.

Fiscal policies need to be dominant because fiscal policies can most narrowly target problems. For example, in 2000, the federal government was collecting more revenue than it was spending. Clearly this was anti-inflationary fiscal policy. The fiscal policy targeted the wealthy and redistributed income, a corrective for our inequality problem. The Fed could have played a supportive role by maintaining a more neutral monetary policy. Instead they pursued a course of action that asserted dominance of monetary policy as "the necessary" inflation fighting tool and managed to tank the economy.

The corrective for our current economic "malaise" does not lie with monetary policy. We need fiscal policy to target inflation and address the redistribution issues. This means letting the Bush tax cuts expire and collect more revenue from the wealthy. At the same time, inequality and unemployment can be addressed by fixing necessary infrastructure. This is not inflationary if it does not create excess demand for materials and will not inflate wages because plenty of workers are available to prevent wage inflation. It will help fight inflation if it increases the efficiency of our system (increase productivity). If we had a better fiscal policy, monetary policy would work much better.

[odograph]

Maybe I'd be more comfortable with a "core" that removed volatility automatically, by a filtering or time-averaging function, rather than by arbitrary choice.

I mean, someone at some point decided that removing food and energy made a "core" and now it is?

Did this paper, or do other papers, search wider for optimal cores or is this point testing? In point testing might stars align for favorable data mining?

[roger]

Just out of curiosity - is the first study you cite, which claims that "predictions of future inflation based upon core measures are more accurate than predictions based upon total inflation" saying that - the core inflation rate predicts the future core inflation rate? Because I can't really see its meaning, otherwise. The core inflation rate in 2006 predicted the rise in commodity prices in 2007? Seriously? If one simply decides that the core inflation rate predicts the core inflation rate that predicts the core inflation rate, you turn around in a mental circle with no outlet.

So how well does the core rate predict other matters? Did it predict the rise in housing prices from 2000 to 2006? Has it predicted their fall? Has it predicted the rise of medical costs? Of education? It is one of the ironies of market centered economics that the market is praised for adapting to the price system, whereas prices themselves are considered way too frisky to be enfolded in the noble task of measuring inflation. It is as if a doctor decided that measuring the real growth of a person was way too risky, and made up other measures based on "core relatinships" - and thus paraded around a midget, claiming that he was actually six feet tall.

[paine]

sticky prices and or sticky output
black box notions ...e ??

why sticky
and why are there
such serious variations in the degree
of actual --if not optimal---
price flux potential
from one product market to another ???

is it the case
that relative output prices can
or could adjust around
a stable unchanging price level

--no matter the amount and degree
of episodic uncertain
relative price adjusting---
if each firm didn't have
to operate inside a "financial harness" ??

a harness that is
a reflection of past circumstances (debts)
and future expectations (stocks)

in reality
--- given enough required relative downward price change --

a firm's harness can quickly turn into a gallows

ie a balance sheet of dollar fixed obligations
and earnings sensitive market equity values
both of which effect relative credit worthiness
as well as relative earnings consequences
and can hault operations
of on going outfits idle productive capacity stock piles of inputs and outputs
and most of all idle ready hands and minds

as it is
given these numerous semi-unique
highly firm specific balance sheets

--all of which contain crucial
past not future price predicated
dollar fixed obligations --

and given the consequence
--- obligations are
NOT OUTPUT PRICE ADJUSTING ---
these financial harnesses
cause otherwise forward looking firms
to struggle with financial legacy dangers
that inevitably emerge when total economy wide
real out put value maxing market conditions
would dictate to certain large sectors
not only big relative downward price moves
but big absolute downward price moves

hence a rising price level lifts all outputs

if one or a few relative prices need to soar
the level change needs to accelerate
so adjustments can come at the expense
of ultimate fixed dollar obligation holders
not on going firms
the rentier must be sacrificed
for over all social welfare

[Don Pedro]

Mark,
This is a very useful post, with the best concise explanation of these issues I've ever seen. Thanks!

[kievite]

I think core inflation is an unscientific, voodoo metric as the implicit assumption is that food and energy prices are mean reverting. Even primitive time averaging of costs of food and energy looks like a more scientific approach.

Using core inflation to suppress transitory component in inflation is an obvious sign that most economists never manage to understand the concepts in the university statistics course.

The concept originated during Arthur Burns tenure I think and was introduced for obvious political reasons. Greenspan became a big promoter of the concept for the same reasons.

[paine]

roger
you turn in your own self created perplexity
the prediction is of the pathway of the general price level

core price moves are ongoing drivers of general inflation
episodic relative surges of individual prices can force up the rate momentarily

the prime mover
a waltz between rising production wages
and net output margins

in the long run
individual commodity price moves
settle down
but the primordial class dance goes on and on

[anne]

http://www.nytimes.com/2008/08/29/business/29econ.html?hp=&pagewanted=print

August 29, 2008

2nd-Quarter G.D.P. Revised Higher
By MICHAEL M. GRYNBAUM

Gross domestic product increased at a 3.3 percent annual rate in the quarter, the government said, which was much better than its initial estimate.

[The stimulus was effective.]

[paine]

"the implicit assumption is that food and energy prices are mean reverting"

given with secular general inflation
ie an upward moving mean i agree and consider it sensible
medium term shifts cycles of commidity price yes

run away raw commodity total output value shares no

only in the ricardian-malthusian wonder land
of fixed technology ...

at least not till peak oil
and or the long anticipated population limits
become the seventh cavalry from hell
and not as they are today
just the vicious wish dream
of affluence rejecting self restricting
anhedonic -nervosa type
green hopers

[paine]

can core rates predict asset prices

once bubbles pop the truth is revealed

asset prices may interact with product prices
in some mutually determinative way short term
but the orginating impetus
rests with product prices
which ever side starts a relative surge
its ultimately only sustained
by the validation of ongoing product market price paths

[paine]

[The stimulus was effective.]

true
but too small by a factor of ten

[Lafayette]

rdf: It's a pity to see well thought out postings get pushed down memory hole.

Hear, hear.

[flow5]

50% of the population has an IQ over 100 & 50% has an IQ under 100. It is those people under 100 that we have to worry about.

"Attempts to measure the aggregate rate of price change—no matter how sophisticated—remain imperfect" THIS IS OF COURSE PURE TRIPE.

First, there is no ambiguity in forecasts. In contradistinction to Bernanke (and using his terminology), forecasts are mathematically "precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; & (4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;

Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.

The lags for monetary flows (MVt), i.e. proxies for real GDP and the deflator are exact, unvarying, respectively. Roc’s in (MVt) are always measured with the same length of time as the economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).

Not surprisingly, adjusted member commercial bank "free/gratis" legal reserves (their roc’s) corroborate/mirror, both lags for monetary flows (MVt) –-- their lengths are identical -- (like Max Planck's constant).

The lags for both monetary flows (MVt) & "free/gratis" legal reserves are indistinguishable. Consequently it has been mathematically impossible to miss an economic forecast (bubble).

There are no inaccuracies, just some non-conforming & unavailable data (e.g., revisions have been overlaid & lost, flawed classification). This is the “Holy Grail” & it is inviolate & sacrosanct.

The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly.

Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.

Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.

Some people prefer the devil theory of inflation: “It’s all Peak Oil's fault.” This approach ignores the fact that the evidence of inflation is represented by "actual" prices in the marketplace. The "administered" prices of the world's oil producing countries would not be the "asked" prices were they not “validated” by (MVt), i.e., validated by the world's Central Banks.

[Dennis]

Thank you for this explanation - I've always wondered about core vs. total inflation and never saw a good explanation. I don't have the economics background to verify that what you say is true re: core inflation, but at least it makes sense.

[daveNYC]

I still don't understand why food and energy are just tossed as opposed to having their data smoothed out with an x month average or the like.

[dWj]

Odograph: I think you'd like the Dallas Fed's trimmed-mean PCE. I do.

Mark: The correct answer to any question of the form, "What's the proper way to define x?" is "It depends on what you're using it for." Thanks for spelling out for us how the right way to measure inflation depends on the purpose.

[anne]

Paine:

[The stimulus was effective.]

true
but too small by a factor of ten

[Agreed, but necessary to notice; and the entire stimulus has been poorly designed at that.]

[Patrick]

I really get bored with these dogmatic arguments and wrangling over definitions. How about we think about the current forces at work instead. Consider this one factor: the price of energy (e.g. oil) has increased. Energy is an input into the production of, well, everything. This leaves producers with two options: pass on the increased costs by raising prices, or accept lower profits. In the first case, prices go up which is inflation by most definitions. In the second case, you probably get some unemployment and reduced consumption. Hmmm ... higher prices, higher unemployment, reduced consumption. Sounds familiar? Sure, the price signals might eventually get people to reduce energy consumption, and probably the inflationary effects will be countered by the opposite forces, but this takes time. In the interim, we get a lot of mixed signals and thrashing as the system adjusts.

[ampersand]

so adjustments can come at the expense
of ultimate fixed dollar obligation holders
not on going firms
the rentier must be sacrificed
for over all social welfare

Idiocy. Fixed dollar obligation holders are the rentiers? Which utopia do you live in? Care to substantiate this claim?

I am not even sure what you intention is here - are you claiming that the class known as rentiers mainly hold bonds?

The rentiers are rentiers, because they hold inflation proof assets, pricing power and they are the first in line to receive newly created money.

A better case of cannibalism than the current inflation racket cannot be found - one set of workers leech off the savings of another set of workers, the rentiers in between collecting rents. Zero inflation in wages, max inflation in prices, and low interest rates.

Workers and retirees are having their income slashed.
Producers and rentiers seeing their income keep up.

And all in the name of punishing rentiers.

[MinniRenter]

How does the Fed compensate for the fact that they set monetary policy for a much broader economic entity than the geographic U.S.? I look around and see inflation in tradable goods and deflation in nontradable goods. It seems that the Fed Funds rate is too low for the economic entity that it applies to, but may in fact be too great for the geographic entity that the Fed is targeting.

[Wolf]

bkaho,
Many years ago (5-8) I doubted your reasoning (I believe we had a brief exchange on DeLong's blog). My apologies.
I thought the market would take care of it(eventually lead to rising wages in line with productivity growth, a more rational allocation of credit, shareholder activism, etc.).

Subsequent developments and further reading (Galbraith, Krugman) set me straight.

You may not remember any of this, but I just wanted to let you know.

[paine]

ampersand
"The rentiers are rentiers, because they hold inflation proof assets"
use the word rentier as pleases u

this however seems a bit unclear

"they are the first in line to receive newly created money"

do u mean the banks ???
are we here defining institutions
or actual
flesh and blood trolls

"the class known as rentiers mainly hold bonds?"
and 'commercial' real estate and common stocks and etc
anything earning an effortless dollar return

i indeed use the word rentier more conventionally
as the class of passive coupon klippers

"one set of workers leech off the savings of another set of workers, the rentiers in between collecting rents"

i like your rage but its agin who ???
what i take to be the hi fi wing of the TNC global menace ???
the frost giants in our market world's mythos
thse two sets of "workers "
one saves and the other borrows ??

then this ...

"Workers and retirees are having their income slashed.
Producers and rentiers seeing their income keep up."

retirees ??
retired workers ???
or retired rentiers too ??
and what of these "producers"

they be producing what ????

rents ????

5flow is fugal chaos
but despite much clarity
Amp
you are COMPOSING beyond 12 tone

[David Merkel]

My econometrics is rusty, but here's my two cents:

http://alephblog.com/2008/02/27/the-problem-of-publishing-in-the-social-sciences/

[paine]

PATRICK

in large part
the core rate calculation
attempts to capture
the contribution to general inflation
of any underlying on going wage profit spiral

btw
sometimes repeating a shared narrative
one that all agree
adequately enough
describes the relevent events in outline
---as you have done above ---
is as useless
as repeating dogma

the distinction
between a relative price changing
supply or demand shock
and
any endemic price level lifting process
ie any ongoing inflationary forces
is not hair splitting

the spreading waves of one shock event
no matter how prevasive or large
the shock (or series of shocks) may be
is a very different criter
from a wage fleeing price hike pass thru process
which like a cat chasing its tail
since the tail can't be caught
has no necessary
point of termination

says...

If you are a worker, you have seen your "wealth" (assets) rising a little and seen it vanish under the Greenspan regime. Net savings? Zero. You have been seeing your income fall in real terms all along.

I don't see that happen to the execs of Exxon, the Walton or Koch brats. (who are the real rentiers). Even if they are retired rentiers.

You policy is the hallmark of third world nations - under-counted inflation, a permanent elite, and a perpetual working class whose savings get devoured by inflation.

It is all done in the name of providing full employment to the working class.

In effect it is a con job - the workers can never, ever, through savings get a share in the control of production, and the rentiers never ever lose their control of the same.

Workers should never ever be able to save, because then they could take control of production from the rentiers. This is not some crackpot question of about whether all workers get to do this - rather it is about can any worker do this? Can any rentier find his wealth decaying, unless he works?

Is that possible under the Greenspan regime? Show us.

You want full employment? Confiscate the Koch and Walton wealth and fund govt programs that create employment.

Or have high wage inflation and high interest rates.

The Greenspan monetary regime is just a plutocracy program.

All the economists like Altig, Hamilton and Thoma and co are feverishly executing a cover up for their failed doctrine, trying to pretend that they can salvage it and save its reputation and make it work, can you all please move along?

Why should they be allowed this free-pass? They have been complicit to the core in this looting of the workers. And now we should believe these people will fix all this and make it right? These egomaniacs who are not even ready to accept that their misguided doctrine is the cause of all this? Who are still trying to salvage that bankrupt doctrine?

Who cares if core inflation is the bedrock of their doctrine, it is right or what not? These bunch of abettors must go. The twenty years they regulated the machine was the greatest transfer of wealth from the workers to the plutocrats.

I don't care a whit if their 'science' is correct or not. The policy that flowed from that was PLUNDER.

The tragedy of Friedman is that his doctrine has been tried.

[Alfred]

"Third, and this is the function that is ignored most often in discussions of core inflation, but to me it is the most important of the three, it is the inflation target that best stabilizes the economy (i.e. best reduces the variation in output and employment)."

It seems to me that this is the problem. Core inflation as a flawed inflation target has draged us into this mess in the first place. The trade off between inflation and output/employment as proposed by the Taylor rule is wrong. There is no link between monetary policy and fiscal policy. Low interest rates facilitate the growth of money stock but have no influence whatsoever on allocation of liquidity. While this trade off can work over the short to medium term, as experienced in the 15 years from the mid 80s to 2000, it is doomed to fail over the long term. August 2007 marked the demise of the Taylor rule. It will take time but economic textbooks will be re-written.

[Elliot Williams]

A good explanation of the "core" CPI, but I'll take issue with one claim: the "core" is not a better predictor of the CPI-U than the CPI-U.

To assert that the "core" is a better predictor is to claim that food and energy price movements have no predictive power for future CPI-U. This is demonstrably false: both food and energy have recently been trending, and are components of CPI-U. To ignore the drift term in food and energy is to underestimate CPI-U inflation.

Try the following simple experiment if you don't believe me. Take percent changes of a CPI series and of a "core" series. Regress CPI_t on CPI_(t-1) + ... and then regress CPI_t on core_(t-1) + ... You may also wish to try it with rolling-windows. Either way, the CPI-based models will outperform the "core"-based models. I've tried it at a horizon of one-month, six-months, and one year. The result is uniformly favorable to the CPI-U.

The difference between my experiment and the Kiley paper is that we take different measures as our target "underlying" inflation measure.

His "underlying" inflation is an average of All-Items and the "core". It thus understates the importance of food and energy relative to my favorite measure of underlying inflation, which would include food and energy as per their expenditure weights -- the CPI-U.

So Kiley removes some part of food and energy, and then finds that the "core" predicts that series better. I am not surprised. When I leave food and energy in, the CPI-U outperforms. Again, unsurprising.

Your third point, that "core" may be the right target for Fed control is quite plausible. I don't understand the monetary transmission mechanism well enough to comment either way. But I swear if I hear "the core better predicts long-run inflation" again, I'll scream. It is a different measure, that differs simply by the changes in food and energy.

The "core" certainly predicts the future "core" better. Is that inflation?

[rufus]

"paine says...in the long run
individual commodity price moves
settle down
but the primordial class dance goes on and on"

Agreed, but the dance becomes more improvisational, when commodities experience long sustained shifts in supply or demand, but as Mark has noted this process is not perfect and the Fed does have the opportunity to think on it's feet.

[paine]

".. it is a con job - the workers can never, ever,...
get a share in the control of production, and the rentiers never ever lose their control of the same"

agreed

[bakho]

http://economistsview.typepad.com/economistsview/2008/08/why-do-we-use-c.html#c128178668

To be fair, Mark has been a supporter of infrastructure spending and a supporter of sound fiscal policy. He has a more balanced approach to policy prescriptions than the over exuberant cheerleaders of monetary policy dominance.

He is trying to educate people on the information the Fed uses to make its decisions.

[cm]

My rationalization of the "benefit" of considering core inflation is that by removing the least-discretionary goods categories that most strongly command price (necessary staples), the more-discretionary categories will capture a "money sloshing around" phenomenon better.

The supposed (i.e. imputed by me) rationale behind this is that the aggregate population/economic actors are deemed to have too much money in their pockets (the practical indicator of inflation?) when even the most discretionary goods/services will command price increases, given that necessities always command price increases.

Aside from that being my own speculation, the issue with any indicator is that it has to be considered in the context of its definition/purpose.

Core inflation and hedonically adjusted inflation/GDP measures however have clearly been repurposed for "prosperity" spin.

[cm]

On a related note, I'm under the impression that over the last let's say half year grocery price hikes have moderated if not reversed, considering frequency of sales actions and "sale" prices which have returned to prior years' levels after a period of "slim pickings" with "sale" prices being merely the price of a few months ago before the latest hike.

When sales become so frequent, the "value deal" effectively becomes the real deal, or at least grocery prices will stabilize "in toto".

Even with my favorite "niche" bread, the maker and stores apparently had to lower the price and revert to a more reasonable delivery schedule, after apparently a pain point had been reached price wise and with delivery schedules cut to the point where empty shelves and stale bread were the norm, probably leading to people substituting away. Now the bread even sports a date stamp.

I'm not sure whether I should welcome this as a good sign. This can only be an indicator of customers scrimping on groceries, and the supply chain having to swallow a larger portion of increased distribution costs.

[Lafayette]

Critique can be helpful

flow5: The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly.

Nice post. But this bit cited above, fairly important, seems tritely nagging.

How does it change our perceptions as regards policy making? Never mind the exactness of the numbers. The numbers, as they are, are all we have to go on. Nitpicking on how to massage or tweak them will not enhance our analytical means one helluvalot.

When I see this continual faultfinding of the numbers in blogs, I am reminded of a Leonardo DaVinci story (or, is it Michelangelo, I forget). Every time he allowed someone into his workshop, they would criticize his work. Why was the arm like this, why the leg like that, why so large, why so small?

He got so fed up that he finally allowed No Visitors into the workshop in order to get on with his creation.

My point: Critique can be helpful, when appropriate. Otherwise it is distracting.

[cm]

Lafayette: Be serious. People are always complaining. Usually that's an indicator of actual issues with something (much of the time with the subject of the complaint, but also often enough it's a matter of projection). When everything is nice and dandy, people generally don't complain. And since when has absence of complaint or constant exhortation ever improved anything?

You can be sure that your artist, whoever it was, was himself the most ardent critic of his own work. We won't know, but I'm quite confident that he didn't bar visitors because he didn't welcome critique, but because he didn't welcome it from those without the standing to provide it.

Now you can of course claim we don't have the standing to critique or criticize econometric methods, aside from the question what would establish such standing to begin with. I argue that we do, by virtue of being subjected to them. We are not criticizing something where we are merely external observers.

[Barry]

odograph says...
"Maybe I'd be more comfortable with a "core" that removed volatility automatically, by a filtering or time-averaging function, rather than by arbitrary choice."

I'm a statistician, and I've never heard of 'stripping away' the more volatile factors, rather than averaging them. I'm not saying that my knowledge is anywhere near complete, but merely that such a technique is suspicious, at first glance.

If kievite is correct, and this originated in Burns' tenure, then we're got probable cause to put it on trial.

Invisible Hand's comment in the post 'GDP Growth Revised Upward
' (http://economistsview.typepad.com/economistsview/2008/08/gdp-growth-revi.html#c128195516) says that some government figures are ignoring the rise in oil prices over the past seven years.

I once asked Brad DeLong about when long-term price increases were no longer considered to be 'volatility', to be stripped out - he didn't answer. I wonder what the answer it.

[Patricia Shannon]

Come on, does anybody, except maybe B J Feng, really believe that if deleting food and energy from the definition of "core inflation" made the inflation figures look worse, that they would have been deleted in the first place? Well no, they probably would have been given double value, under that rational that they are so important in people's budgets.

Humans are rationalizing, not rational, creatures.