Headline vs core inflation links

The debate continues…

William R. Cline and Joseph E. Gagnon discuss (transcript here) which is a better measure for inflation. Gagnon of NY Fed prefers the core and Cline says looking at core ignores the trend of persistent rise of food and fuel prices. Cline says:

There’s a problem. Food and fuel prices have two components of information. One is volatility, and that’s disinformation. The other is the long-term trend. That’s information that you throw out if you just use so-called “core inflation.” I was taking a look at this and was surprised to see that in eight out of the nine last years, the rate of “headline inflation” [which includes food, energy and commodity prices] has been higher than the rate of core inflation. That can happen one or two years in a row. But not when it’s up to eight out of nine in a row. The chances of that happening on a random basis are 1 out of 60.

So something is going on that suggests there is more than a random volatility involved here. It seems to me it’s consistent with growing concern about resource scarcity, about the fact that countries like China and India are growing very rapidly. They are a larger fraction of the world GDP and they are more resource-intensive in their growth than we are. Or concerns about things like erratic weather from global warming, causing commodity disruptions. So I think that we should start thinking about giving more weight to headline inflation, especially after a number of years have passed when there’s been a persistent excess of headline inflation over core inflation.

 This can get mischievous. I happen to think now that the low interest rate policy in 2003-06, which I think contributed to the Great Recession and the financial crisis, was aided and abided by looking at core inflation instead of headline inflation. The average headline inflation in that period was 2.9 percent; the average core inflation was 2 percent. Two percent is fine, so it’s justifiable to continue to have lax monetary policy. So I don’t think this is totally innocuous.

Cline suggests Fed could instead have a weighted average inflation and give more weight to headline if it is higher than core. He refers to history when Harold Hotelling proposed a rule that said price of natural resource should rise at rate of interest. He said this at that time when the prices of fuel etc were rising in 1970s. However, since then prices have declined leading to rule not becoming true. We are back in similar times:

Let me put this in an abstract or theoretical context. There is this guy called Harold Hotelling who decades ago said that the price of a scarce natural resource should rise at the rate of interest. Well, the interest rate equals inflation plus the real interest rate. So if the real interest rate is like 2- 3 percent, we’d tend to think by definition — if the resource is really scarce — its price should rise faster than general inflation year after year. And that kind of a concept would make you think if you had a smart, undergraduate who is asked about core inflation and headline inflation, his answer should be that because of Hotelling, headline inflation should always be higher than core inflation. So you’ll be fooling yourself if you think that core inflation is going to give the best picture. What we found out over decades was, instead of ever-rising commodity prices, they seem to be ever falling. After 1973 or so, you had basically this gradual decline in real commodity prices. But I think there’s considerable concern that we’re back in a period where the perception of limited resources and something more like a Hotelling mechanism, certainly for oil, might be more relevant.

Superb stuff. History again comes back. May be again our predictions come wrong or may be Hotelling rule comes true now. Time will tell.

In another note, Daniel Thorton of St Louis Fed says core inflation has not been a good predictor for headline inflation.

Wlliam Gavin says core CPI and CPI less fuel have similar patterns pointing the volatile nature of fuel prices.

Then there are two papers written by me –

The debates again go back to 2007-08 times.

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