Wednesday, July 11, 2007

The Value of Using the Core Inflation Rate

This article from the WSJ summarizes Ben Bernanke’s position on the use of core inflation as opposed to the CPI for determining monetary policy. I understand the Fed’s position on this issue, however, by only looking at the core inflation rate other problems in the economy are not appreciated. For example, if the energy and food are growing at 6% rate and inflation rate for the entire economy is growing at 4.5% the other components of the inflation rate are declining in price. They are not declining in price because of improvements in productivity they are declining because they are being squeezed out by food and energy and merchants have to drop the prices to make the inventory move. Therefore, by only looking at (or reporting on) core inflation, problems in the economy are being masked. That is why there seems to be all the contradictory reporting about the economy. On one hand the news on the economy seems to be strong and on the other hand a survey by CFOs appears pessimistic.

As food and energy prices climb across the nation, the Federal Reserve is facing growing criticism for focusing on "core" inflation, which excludes both those items, as the basis for its interest-rate decisions.

Ben Bernanke said . . . "Increases in energy prices affect overall inflation in the short run because energy products such as gasoline are part of the consumer's basket, and because energy costs loom large in the production of some goods and services," he said. "However, a one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent 'wage-price spiral.'"

The speech seemed to imply Mr. Bernanke doesn't see that risk at present: "Notably, the sharp increases in energy prices over the past few years have not led either to persistent inflation or to a recession, in contrast [for example] to the U.S. experience of the 1970s."

Inflation expectations, he said, have become much better anchored -- that is, they are pushed around less by swings in energy prices -- since the 1980s, but aren't "perfectly anchored."
The Fed believes that because it has little influence over short-run energy prices, shifting monetary policy when those prices push headline inflation up or down could be harmful -- for example, raising rates when gasoline prices rise during the summer driving season, then reversing course in the fall. The Fed's interest-rate decisions are designed to influence the overall economy over a horizon of one or two years.

When oil price spikes were temporary, overall inflation rapidly returned to the underlying core trend. But unlike previous spikes in oil and food prices, the latest ones are driven by rising global demand, not interruptions of supply. As a result, unlike in the past, said Paul Ashworth, senior U.S. economist at Capital Economics, "it could be more likely that the gap would be closed by core inflation moving toward headline inflation."

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