Core Inflation vs Headline Inflation

I am just trying to catch up with times after the long vacation. I just read this excellent speechfrom Mishkin where he discusses which inflation measure is better in monetary policy- headline or core?

For the uninitiated, Headline inflation is your general index like WPI (for India), CPI etc. that includes all the items used for measuring inflation. Core inflation index excludes a certain items whose prices are more volatile and hence may not represent a true picture of the inflation.

Most countries have their own baskets of goods and services on the basis of which they make an index and inflation is tracked.  But, the excluded items from core inflation are mostly fuel and food items. As both are quite important items for consumers (households) should they be excluded? Or in other words do we need to at all follow core inflation?

Mishkin says yes, despite the problems it makes more sense for a central banker to follow core inflation than headline inflation.

 When a cold snap freezes the Florida orange crop or a tropical storm hits the gasoline refineries along the Gulf Coast, monetary policy cannot reverse the resulting spikes in prices for fresh orange juice or for gasoline at the pump.  Temporary supply shocks such as these raise the prices of food and energy relative to other prices and can have substantial effects on inflation in the short run.  By including all items–including particularly volatile items like food and energy–headline measures of inflation are inherently noisy and often do not reflect changes in the underlying rate of inflation, the rate at which headline inflation is likely to settle and that monetary policy can affect.

Research has shown that headline inflation tends to revert strongly towards core inflation over a time period making the case for core stronger.  

Thus, as long as the permanent change in relative energy prices does not lead to a change in the underlying trend rate of inflation–a crucial assumption–then headline inflation will come back down again.  This is what we seem to have seen recently in the United States.  From a low near $30 per barrel in late 2003, the price of oil rose to $70 per barrel by the middle of 2006, and it has stayed high, with the current price more than $80.  That move increased headline PCE inflation to the 4 percent level for a time, but it has since retreated to around 2 percent

However, it is important to distinguish between temporary and permanent changes in prices. Temporary changes would reverse and do not warrant attention but permanent changes especially in the case of oil prices is important.

He goes on to show how economy would look if Fed responds to a oil shock by looking at both headline and core inflation.

The federal funds rate jumps higher and faster when the central bank responds to headline inflation rather than to core inflation, as would be expected . 

Likewise, responding to headline inflation pushes the unemployment rate markedly higher than otherwise in the early going and produces an inflation rate that is slightly lower than otherwise, whether measured by core or headline indexes. 

More important, even for a shock as persistent as this one, the policy response under headline inflation has to be unwound in the sense that the federal funds rate must drop substantially below baseline once the first-round effects of the shock drop out of the inflation data. 

Responding to headline inflation is therefore inappropriate because it generates extensive variability in the unemployment rate–variability that is much more subdued when policy responds to core inflation

Then he discusses various ways to measure core inflation and why central bankers need to also look at headline inflation. He stresses that Central Banks should clearly communicate their strategy to fight inflation which would lower inflationary expectations in the economy.

Excellent speech from Mishkin. Go through the rich reference list as well.

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