Thursday, August 4, 2011

The Dispute over "Core Inflation"

Is there a danger of inflation taking off? When the price of gasoline and food shoot through the roof, it seems like it. But central bank officials calmly comment that it makes more sense to focus on "core inflation," which strips out energy and food prices, on the grounds that these prices fluctuate a relatively large amount, and thus give a distorted view of the inflation that is actually occurring. Of course, this leads a lot of distraught citizens to respond that they have to pay for energy and food, whether the central bank thinks that those prices are relevant or not.

Zheng Liu and Justin Weidner of the San Francisco Fed  argue that "headline inflation," which is the announced rate of inflation including energy and food, does tend to converge to "core inflation," which strips out those factors, which implies that a central bank focus on core inflation makes sense. On the other side, James Bullard of the St Louis Fed argues in "Measuring Inflation: The Core is Rotten," that the Fed should focus on headline inflation.

As a starting point, here's a figure from Liu and Weidner showing headline and core inflation over time.

The figure suggests several interesting patterns and lessons. 

1) Over time, headline inflation is a lot more volatile than core inflation. This is often used to upports the Fed case that focusing on core inflation makes sense, because focusing on headline inflation raises a risk of  overreactions and excessive volatility in monetary policy. However, as Bullard points out, reacting to a less volatile measure of core inflation poses risks of overreacting, too. Bullard writes: 
"On the topic of the volatility of headline inflation, the headline index can be smoothed in any number of other ways that stop short of ignoring a wide class of important prices in the economy. One simple way is to consider headline inflation measured from one year earlier, but there are many others. To the extent that the volatility of headline inflation is a problem, there are better methods of addressing that than to simply dismiss troublesome prices."

2) There is dispute over whether core inflation is a better predictor of future inflation than headline inflation. As Liu and Justin Weidner write: "In the 1960s through the 1980s, deviations of headline inflation from core seem to have been resolved by core inflation catching up with headline. For example, the two episodes of high headline inflation in the 1970s were followed by significant run-ups of core inflation. However, since the early 1990s, core inflation has remained stable despite fluctuations in headline. This observation is confirmed by empirical studies and formal statistical analysis showing that the behavior of inflation has substantially changed since the late 1980s and early 1990s ..." On the other side, Bullard sets a skeptical standard for such evidence: "Suppose we have a full model of the inflation process, one that includes expected inflation, measures of real activity, and measures of the stance of monetary policy. We then add core inflation as a variable to this model and assess the marginal predictive value of core inflation given all other variables. If the marginal value of adding core inflation in this context is positive, one might then have a claim that core inflation contains some “special” information over and above information coming from the rest of the economy concerning the future course of inflation. I have not seen convincing evidence of this type."

3) Are movements in energy and food prices just adding volatility to measured of inflation, before they return to near long-run levels, or are they in the middle of ongoing trends? Bullard warns that we have common examples of long-term trends in certain price levels, and so this possibility shouldn't be disregarded. "One might also reasonably question the “temporary” characterization of the shift in energy and other global commodity prices. It is certainly true that we should not expect energy prices to increase faster than the general price level without limit. But it is also true that there are wellknown
examples of long-term secular trends in certain prices. One example is medical care prices, which for decades have generally increased faster than the headline CPI index. Another example is computing technology, where prices have more or less continuously declined per unit of computing power, even as other prices have continued to rise. So it is possible—and indeed it does happen—that whole sectors of the economy experience relative price change."

My own sense is that its almost always possible to construct a situation in which an overly mechanical rules for central bank behavior won't work well. The central bank should certainly look at what factors are affecting headline inflation, and adjust its reactions in light of which factors seem to be operating. Such adjustments will sometimes have the affect of looking at "core inflation." But announcing publicly that core inflation is your goal and defending that goal in front of incredulous citizens and reporters seems overly rigid and a certain PR disaster.

Fear of inflation really should the least of our economic troubles during this Long Slump of a quasi-recovery. Indeed, a bit more core inflation would cut real wages, which might help a bit in increasing hiring. It  would reduce the federal debt burden as a share of GDP (because past debts could be repaid in inflated dollars). It would made a deflationary scenario much less likely, which allow the Federal Reserve to stop running near-zero interest rates and start getting the financial sector back on a more normal footing. A few weeks back I asked one of my macroeconomist friends whether we should be worried about a resurgence of inflation. He replied: "We should be so lucky."