Core inflation is rotten

Says James Bullard of St Louis Fed in this provocatively titled and insightful speech. The list of readings on headline vs core just keep rising. This ppt gives a nice overview as well

In this speech, Bullard clarifies why core inflation is not the right measure for inflation. By focusing on core we are going to underestimate inflation. Instead of looking at headline vs core debate, Fed should fix headline inflation as its target inflation and announce it like the inflation target central banks:

In my remarks tonight I will argue that many of the old arguments in favor of a focus on core inflation have become rotten over the years. It is time to drop the emphasis on core inflation as a meaningful way to interpret the inflation process in the U.S.

One immediate benefit of dropping the emphasis on core inflation would be to reconnect the Fed with households and businesses who know price changes when they see them. With trips to the gas station and the grocery store being some of the most frequent shopping experiences for many Americans, it is hardly helpful for Fed credibility to appear to exclude all those prices from consideration in the formation of monetary policy.

There are several key arguments that are commonly used to favor a focus on core inflation in monetary policy discussions. I will argue that all of them are essentially misguided. Because of this, the best the central bank can do is to focus on headline measures of inflation. The headline measures were designed to be the best measures of inflation available—the Fed should respect that construction and accept the policy problem it poses. Many other central banks have solidified their position on this question by adopting explicit, numerical inflation targets for headline inflation, thus keeping faith with their citizens that they will work to keep headline inflation low and stable. The Fed should do the same.

What are the arguments for core?

1. The “volatility” argument — Econs says headline more volatile than core. Bullard says this does not matter as policy can be made based on measure of inflation. people use headline inflation in rules designed for core inflation and voce-versa which leads to poor results. He turns the debate on its head:

One might very legitimately turn the headline volatility question on its head. With core inflation as the preferred index for monetary policy analysis, the policymaker will tend to react to relatively small movements in measured core inflation. In that case, arguably, any policyresponse has to be larger—possibly substantially larger—when even small changes in measured core inflation are observed in order to execute the optimal policy. This may be ill-advised to the extent that small movements in core inflation are in fact simply noise.

Econs call movements in headline as noise; here he calls core movements as noise.

He adds policy in 2007-09 crisis shows headline inflation works well.

Recent experience offers something to ponder in this regard. While many think that the recent financial crisis provides an illustration of the merits of the focus on core inflation, I do not see it that way at all. During the second half of 2008 and into 2009, headline inflation measured from one year earlier fell dramatically and in fact moved into negative territory. This was a signal—one among many, to be sure—that a dramatic shock was impacting the U.S. economy. Inflation was not immune to this shock. The FOMC reacted appropriately with an aggressive easing of monetary policy. Yet the movements in core inflation during this chilling period were far more muted and sent much less of a signal that action was required.

He points headline inflation can be smoothed (using YoY instead of MoM; we know in India both are volatile). Also says using core as an intermediate measure leads to policy slippages from the headline target.

2. The “core predicts headline” argument — points to studies which does not show any such relationship. He points people wrongly model core inflation as a single factor for headline inflation. Once we include more factors like say output, expected inflation etc, we don’t see any relation.

The “relative price” argument — In this econs say Fed cannot control all prices. Some prices like oil and food are out of control. Bullard says this applies to all the prices:

It is often asserted in discussions of this type that the Fed cannot help the fact that events occur around the world each day that affect various prices. Some prices are “out of our control.” This is certainly true, but this is also true for every single price in the price index. Each one is affected by real supply and demand factors each day, none of which is susceptible to direct influence by the Federal Reserve. The only element of control the Fed has is over general movements in the entire price index, and only imprecisely over a period of quarters and years.

He says one cannot assume prices of crude and food to be temporary given surge of emerging economies which try and converge their incomes with developed world.

Should the central bank target a subset of prices? He says this is more sophisticated reason but not widely discussed

The last set of arguments in favor of a notion of core inflation is far more sophisticated, but also far less established. Up to now we have taken it for granted that the prices that households care about include all the prices that households actually have to pay. This suggests that our existing headline price indexes are the right ones to look at when considering what is best for households. Yet there is some interesting literature that asks the following question: Can we think of a theoretical world in which the central bank would want to target a subset of the prices faced by households, instead of all the prices, on the grounds that this policy would be preferred by the households themselves? We could then call changes in this subset of prices “core inflation.”

He suggests more discussions on these lines. Instead of econs assuming that people care only about few prices, we should actually figure what prices people care about. This could then be called core prices.

Superb speech covering many issues.

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One Response to “Core inflation is rotten”

  1. SRINIVASAN Says:

    Read the report. Its interesting that the indians also perceive that headline and core inflation are one at the same. Thanks to the report, which distingush the core Vs headline.

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