Should central banks be focusing on headline inflation going forward?

Two very interesting thoughts. First from Luis AV Catão and Roberto Chang and second from Lorenzo Bini Smaghi.

Roberto and Luis have done this paper and summarise findings in voxeu.

Rising food prices once again pose central banks a tricky question. How far should they ignore food price inflation? This column suggests that food tends to have stronger predictive power on global inflation cycles than oil. The problem is more severe in emerging markets where consumption basket weights for food are two or three times larger than in rich nations. Central banks should pay close attention. 

In the paper they show how central bank inflation targets are missed whenever food prices have surged. So food prices have a broader impact on inflation than suggested. They say US and EMU should look at these food prices as their decisions have a broader impact on world economy:

Against this background, a key question to national central banks is the extent to which such imported inflation should be accommodated. In the case of large central banks like the ECB and the US Federal Reserve, two considerations stand out.

• The first is that their actions have a direct bearing on global food price given their weight in world income and capacity to set world interest rates, influencing food prices via both demand and supply channels.
• The second is that their actions have strong externalities elsewhere. In the emerging/developing world, this can be far-reaching because food accounts for a very high share in consumer spending and, since much of it consists of non high-end items, it cannot be substituted away.

Well-known structural weaknesses of developing countries add to the problem. Soaring food inflation can trigger far-reaching unrest wherever political institutions are fragile, financial systems are less mature to smooth out shocks, and social safety nets inadequate, as witnessed by the many food-related riots during 2007-08.

The authors then show that central banks would be best placed if they target the headline inflation. They also go back to earlier period of 2007-08 when food prices had risen. They show if headline inflation targeted the policy rates would have been higher (except for New Zealand).

Lessons:

Going forward, what lessons can we take from this evidence?

• First and foremost, global food price pressures pose a sizeable threat to global monetary stability.
• Second, they pose an externality problem that demands non-trivial coordinated action by key central banks.

Left alone, we should fear that coordinated action may come in too little and too late because the inflation spillovers are largely felt first in emerging markets (again, much due to higher food shares in consumption baskets) and because individual advanced societies are better equipped to withstand such a price shock at least for a while. So, the associated policy prescription is hardly “one-size-fits all”. These various considerations suggest that strict and widespread targeting of broad CPI inflation, while not a silver bullet, does help.

To be sure, the more aggressive interest rate reaction to imported food inflation demanded by broad CPI inflation targeting raises well-known problems of its own for the small open economy, particularly regarding capital inflows. Standard macro models featuring complete international capital markets and frictionless domestic financial intermediation are ill-suited to address these problems. While developments in this area of research are promising, they still fall short of offering clear-cut prescriptions to policy makers. Absent that, the targeting of broad CPI inflation, when consistently implemented, appears to be a stronger contender than other rules in terms of mitigating monetary policy externalities on a global basis and helping keep global inflationary pressures at bay.

Smaghi, who has been off the lecture circuit for sometime starts the year with some interesting ideas. He says that adv eco central banks can no more ignore the global/imported food inflation as this would imply missing inflation targets persistently. In that case, domestic inflation has to be much lower.

The second challenge, related to the first, concerns the difficulty in estimating inflationary pressures and in forecasting them. In addition to the factors highlighted before, a new aspect has emerged in recent years, linked to the increasing importance of global inflation, tied to the commodity markets and products imported from emerging countries. The dimension attained by the emerging countries means that this phenomenon can no longer be ignored. Furthermore, the impact of inflation imported from these countries is likely to be of a different nature than in the past.

In conceptual terms, inflation caused by imported products, especially commodities, can be ignored under three conditions. The first is that the increases are temporary. The second is that the imported price increases do not cause dragging effects on the price dynamics of domestic products. The third is that such increases do not have any effects on the inflation expectations of market participants.

In the recovery phase in the 2000s, only the third condition was maintained, in part. Contrary to what was initially thought, commodity prices have steadily increased, not only in terms of their level but also in terms of growth rates.

Now imported inflation is likely to remain with rising EME demand. This leads to two kinds of impacts:

In any case, a permanent and repeated increase in the prices of imported products will tend to impact on inflation in the advanced countries, including the euro area. This effect occurs through two channels. The first is simply mechanical, by the weight of imported goods in the basket of goods and services purchased by households. For example, food and energy account for about 30% of the average shopping basket in the euro area. Assuming an average increase of these products by 4% a year, more or less in line with the rate of growth of the world economy (or long-term interest rates, according to the Hotelling rule), average prices in the euro area will increase by 1.2% only because of the effect of these products. It is therefore not a component that can be ignored, as it would be if core inflation were used as a reference. This concept is obviously losing its relevance in a global world.

The second effect concerns the implications for prices of other products, making up 70% of the basket, and which include manufactured goods and services, some of which are imported and others are produced domestically. Assume, for simplicity’s sake, that these goods are only produced domestically. If the prices of these products grow at a rate of 2% per year, overall average inflation is 2.6%, exceeding the 2% objective of most central banks in advanced countries, including the ECB, which aims for inflation of below but close to 2% over the medium term.

Hmm.. This leads to two choices for central bank. Either raise inflation targets or lower domestic inflation:

The central bank is therefore faced with two alternatives. The first is to revise the inflation rate objective upwards, taking account of imported inflation, or only to look at non-imported inflation and to ignore the rest. This strategy is complex because first and foremost it is not clear how much the imported inflation rate will be going forward, which is not under the control of the central bank. In addition, an upward revision risks bringing a loss of credibility and of being interpreted as a change in strategy. Moreover, a higher inflation objective implies an increase in inflation expectations, and thus of long-term interest rates, which must sooner or later be accompanied by an increase in short-term rates. Finally, if the inflation rate objective is increased it will not be easy to convince national market participants not to include this increase in their behaviour, including in wage demands. In a situation of high unemployment, this risk is limited, but gradually as the economic recovery gets under way the risk of second-round effects increases.

Alternatively, the central bank may decide to maintain the inflation objective unchanged at 2% (or less). In this case, since the contribution of imported inflation is 1.2%, this means that domestic products must not increase by more than 1% per year. In other words, to be consistent with inflation at 2%, core inflation, or excluding food and energy, should be 1%. How do you get this result? By focusing monetary policy on domestic inflation of 1%. This can be accomplished through a moderation in costs and prices by producers. This does not necessarily mean a loss of purchasing power, if productivity increases at a pace comparable with imported inflation. However, if this does not happen, the only way of ensuring price stability is to restrict the purchasing power of wages. This requires that price increases for imported goods do not feed into wages and domestic prices.

Raising productivity is a very difficult task. So, in most cases inflation likely to miss targets. In other economies appreciating currency can help but as EMEs are expected to be stronger currencies will appreciate there. So with a depreciating currency, imported inflation only becomes stronger. In the end he says this insight needs to be rubbed in all the price setting bodies:

This factor should be incorporated into the conduct of businesses, trade unions, public authorities. Only by having domestic inflation significantly lower than 2% is it possible to avoid second-round effects on expectations and to maintain an economic growth rate in line with potential. Otherwise, monetary policy has to become more restrictive than it should be, which leads to slower growth, until the behaviours conform to the new standard.

Superb stuff. UK is going through this problem of having a higher inflation on account of depreciated currency and rise in commodity prices. BoE has been missing its inflation target for so many months now. EU too might face this problem going ahead as inflation moved higher than 2% for the first time in 2 years or so.  

It also points to some fresh thinking on headline inflation vs core inflation.  The consensus so far was for core inflation which did not include food and fuel. Now, we might just have to include all to understand the inflation process better. Trimmed inflation measures might end up showing food prices in their indices more frequently with food prices rising and not that volatile over the years.

I was also thinking from India’s perspective. We anyways look at headline inflation more closely than others. The spillover effect of rising food prices to other products is more prevalent here because of higher expenditure on food items. So if they rise, people will demand more wages etc. RBI has raised concerns about the same in the Jan-2011 policy. On these grounds, rate increases or elevated rates will remain with us for a while. Agriculture reforms are one of the  top priorities…

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