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Sunday, August 27, 2006

Should the Fed Focus on Core Inflation or Headline Inflation?

Charles Bean says central banks are mistaken to focus on core inflation rather than headline inflation in their policy deliberations:

BoE hits at US inflation measure, by Krishna Guha in Jackson Hole, Financial Times: The US Federal Reserve is wrong to focus on core measures of inflation that exclude energy prices, Charles Bean, chief economist at the Bank of England, has suggested.

It should focus instead on headline inflation, which is much higher... Including energy and food costs, US consumer price inflation is running at an annual rate of 4.1 per cent, against 2.7 per cent for core inflation.

Mr Bean told the Fed’s annual Jackson Hole symposium ... that energy prices were rising for the same reason the price of many manufactured goods were falling: the rise of China and other emerging market economies. Since both price trends had a common cause, he said it makes little sense to focus “on measures of core inflation that strip out energy prices while not stripping out falling goods prices as well.”

Mr Bean did not mention the Fed by name but his implication was clear. ... Central bankers in Europe take a sharply different approach. Both the Bank of England and the European Central Bank put greater emphasis on talk of headline inflation, which includes the immediate “first round” effect of rising energy prices.

But the Bank of England and the ECB increasingly take the view that energy prices may be on a long-term upward trend, driven by industrialisation and urbanisation in China and India.

David Altig said recently:

Why We Focus On Core Inflation II, by David Altig: From this month's edition of Economic Trends, published by the Federal Reserve Bank of Cleveland (page 3):

What information households base their inflation expectations on is the topic of frequent academic debate. Rather crude correlations, which examine the relationship between realized inflation rates and households’ expectations, indicate that their year-ahead expectations are most closely correlated with the headline CPI inflation rate, and are especially sensitive to this measure over longer time horizons. Interestingly, expectations for the inflation rate over the next five to 10 years are more closely correlated with the core CPI inflation rate than with headline CPI. The correlation also grows stronger as the underlying core CPI inflation trend becomes more persistent. Indeed, ... this may indicate that households see through the same transitory fluctuations in prices that the core inflation measure is designed to isolate.

At a minimum, this means that the FOMC has been pretty successful at getting the public to focus on core inflation as a reasonable measure of the longer-term inflation trend. But it is unlikely that this situation could persist without a central bank that generally delivers the goods, and as I suggested once before, it does appear that, over the medium term, core inflation is a better predictor of headline inflation than is headline inflation itself.

To the extent that stabilizing inflation expectations is the really important part of getting monetary policy right, these sorts of results begin a persuasive case for the use of core inflation as a guide.

I agree with David - I want to see evidence that we forecast future headline inflation better by dropping core measures, and as noted below there are theoretical arguments for using core inflation as well. For now, as David notes, core inflation has the most predictive power for future headline inflation. Notice, however, a difference in the underlying assumptions that drives the use of different measures of inflation. The Economic Trends article sees the difference between core and headline measures as "transitory fluctuations" whereas in Europe energy prices are seen as following a "long-run upward trend." Finally, core inflation measures can be defended on a more theoretical basis, e.g. see here for a summary of Woodford's argument on this point.

    Posted by on Sunday, August 27, 2006 at 04:29 PM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (7)


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