What inflation should Fed target?

Fed is not an inflation targeting central bank but there are enough papers debating the issue. It was quite a debate before the crisis.

Now, when we talk about inflation targeting we get into macro ideas – how does it work, how it leads to lower inflation, how it makes central bank more independent and transparent etc. The questions don’t look at a major issue- what measure of inflation should be targeted?

Take the case of US. It has so many measures of inflation – CPI, personal consumption expenditures price index (PFCE), etc. Which is more appropriate? And then should we look at headline or core?

This paper by Richard Dennis of FRBSF looks at this issue. If Fed adopts ITF, what measure of inflation should it target?

First some limitations of CPI

The United States does not practice inflation targeting. But some of the principles underlying this framework can be illustrated using U.S. data. It might seem natural that a series such as the consumer price index (CPI) would make a suitable target. In many regards, it would be. The CPI features prominently in the business press, it is released in a timely fashion, and it is not subject to historical revision. Moreover, it is constructed by the Labor Department’s Bureau of Labor Statistics, an institution that is independent of the Federal Reserve, which is important from an accountability perspective. However, the CPI was developed to measure the cost of living, that is, the cost of purchasing a particular basket of goods and services. It is not automatic that monetary policy should be directed at stabilizing changes in the cost of living.

In a world with many goods and services whose prices do not change in unison or for the same reason, inflation is most usefully thought of as a generalized upward movement in prices, rather than simply an upward movement in one particular basket of goods and services. That’s true even if the price of that basket is intended to reflect the cost of living. Moreover, the CPI is a fixed-weight index and is known to overestimate changes in the cost of living. Lebow and Rudd (2003) calculate the overestimation to be about 0.9 percentage point per year. By contrast, the personal consumption expenditures price index (PCEPI) is thought to be less affected by this overestimation and is often favored as a measure of changes in consumer prices

The author then says certain items like fuel and food are volatile and monetary policy can do little to lower volatility. The idea is to track inflation based on goods whose prices are sticky or persistent. If we see sustained rise in such goods, central bank should act. He suggests a different index and he calls it as stability inflation index.

Although a wide range of prices could be included, for simplicity I focus on headline PCEPI inflation and its three components: durables, nondurables, and services. To design one possible index, I use a statistical model to relate PCEPI inflation of durables, nondurables, and services…..

Using data from the first quarter of 1985 through the fourth quarter of 2009, the weights that produce the least volatility of economic activity are 0.24 for durables, 0.00 for nondurables, and 0.76 for services. In the headline PCEPI, the weights on these three components are approximately 0.13, 0.24, and 0.63 respectively. The stability inflation index essentially reassigns the weight for nondurables to durables and services. The inflation stability index discounts nondurables inflation and highlights services inflation because an index composed of durables inflation and services inflation is much less volatile than an index that includes nondurables inflation. By discounting nondurables in the index, monetary policy would avoid the disruption of economic activity caused by efforts to offset the transitory shocks produced by nondurables inflation.

Hmmm. He then compares the stability index inflation with core PFCE inflation and Dallas Fed Trimmed mean inflation.

Because this approach is a “back-of-the envelope” calculation, I have not actually constructed a stability inflation index. Instead, I take as a proxy for this index the PCEPI inflation series for durables and services, which is shown in Figure 3, together with core PCEPI inflation and the Dallas Federal Reserve Bank’s trimmed-mean PCEPI inflation (Dolmas 2005). Similar to trimmed-mean PCEPI inflation, inflation in durables and services has generally tended to be higher than core PCEPI inflation. However, in recent quarters, it is notable that inflation in durables and services has fallen rapidly. This suggests an absence of inflationary pressures, consistent with the current high unemployment rate and an economy operating with substantial slack.

So in good times, it has shown higher inflation than usual measures and in current times it shows a much lower inflation showing higher slack in the economy.

Good insights…..

RBI Governor Subbarao also raises the same concerns- which inflation to target? However, this is just ignored and few experts keep saying we need to target inflation etc. They just don’t take this problem into account. We still do not have a proper measure of inflation and talk about inflation targeting……

2 Responses to “What inflation should Fed target?”

  1. Investing is Step 5 of a Do It Yourself Financial Plan - Trade the E-minis Says:

    […] What inflation should Fed target? « Mostly Economics […]

  2. leak Says:


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