Bullard recommends targeting monetary policy at headline, not core, inflation

The Federal Reserve Bank of St. Louis just published an article written by James Bullard, a non-voting member of the Federal Reserve and President of the St. Louis Fed, called “Measuring Inflation: The Core Is Rotten.” It is based on a speech Bullard delivered two months ago to the Money Marketeers of New York University. It is a refreshing perspective on the use of core inflation for guiding monetary policy; it is also a bit surprising coming from someone on the Federal Reserve!

Bullard starts and ends with a critique familiar to those of us who insist food and energy prices should not be excluded from measures of inflation:

“One immediate benefit of dropping the emphasis on core inflation would be to reconnect the Federal Reserve 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…

…The headline measures of inflation were designed to be the best measures of inflation available. It is difficult to get around this fact with simple transformations of the price indexes. The Fed should respect the construction of the price indexes as they are and accept the policy problem it poses. To do otherwise may create the appearance of avoiding responsibility for inflation…”

(Compare and contrast this to Governor Frederic S. Mishkin’s insistence in 2007 that the Federal Reserve should care about headline inflation but focus on controlling core inflation in its public stance on monetary policy.)

I love the recognition that average consumers and businesspeople “know price changes when they see them.” This is Inflation Watch’s reporting philosophy and helps explain my emphasis on reporting the price changes of a broad range of products and services.

Bullard makes some key points to argue that headline inflation can and should be the focus of monetary policy. While I agree with his overall thesis, I do take issue with some of the points (my comments in bold):

  1. Monetary policy can be adjusted to accommodate the extra volatility in headline inflation by, for example, focusing on year-over-year changes.
  2. The relationship between core and headline inflation is unclear and even changes over time, making it more difficult to comprehend the optimal policy response. Me: This was an interesting point since the Federal Reserve’s statements usually imply the Federal Reserve tunes policy for core, not headline, inflation anyway. Currently, Ben Bernanke has all but absolved monetary policy of any impact on commodity prices.
  3. The Federal Reserve cannot directly influence supply and demand dynamics for any particular product in the inflation index, so it is not sufficient to ignore prices that are supposedly out of the Federal Reserve’s control. Me: I understand Bullard’s point, but I also think providing cheap money that traders can easily borrow to bid up the prices of goods and services is a strong and sufficient influence. The Federal Reserve definitely thinks it can directly influence housing demand and prices given its targeted efforts at lowering mortgage rates.
  4. When the price of one good goes up, another goes down as consumers adjust their demand to stay within their budgets. Increasing food and energy prices can thus force other prices down in the core index and further understate true inflation.

Bullard further notes that their is promising research into directing monetary policy at a specific subset of prices that households care most about, but it is too early to use.

Of particular interest to me was Bullard’s identification of a changing world where commodity prices will join the prices of medical care (and education) in outpacing the overall average inflation rate.

“…much of the contemporary worry about commodity prices is that relative price changes may be much more persistent going forward than they have been in the past…

…it is at least a reasonable hypothesis that global demand for energy will outstrip increased supply over the coming decades as the giant economies of Asia, particularly India and China, reach Western levels of real income per capita. If that scenario unfolds, then ignoring energy prices in a price index will systematically understate inflation for many years.”

(See “Preparing for Profits in a Resource-Constrained World” on implications for investing).

Given the limitations and blind spots of core inflation, Bullard makes a convincing case for directly targeting headline inflation with monetary policy. Otherwise, the Federal Reserve remains at risk for maintaining monetary policies that are too loose for too long.

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Changing the measure of inflation to generate more government revenue

I read a short article in Planet Money that reminded me why I tend not to pay attention to official government inflation statistics. The government estimates it could generate $200B in extra revenues over a decade by making the switch. This reminds me that the folks generating the index essentially have a vested interest in the numbers themselves or at least can face political pressures to calculate and/or interpret them in ways favorable to policy.

See “The Wonky Inflation Tweak Worth Over $200 Billion” for more.


The chained consumer price index returns to pre-recession highs

Thanks to a CNBC article titled “US Cost of Living Hits Record, Passing Pre-Crisis High” by John Melloy, I discovered/realized that the chained consumer price index has now returned to its pre-recession highs. This index measures the cost of living for Americans living in urban areas. You can think of it as the cumulative impact of inflation over time. In 2000, this index measured 102 (normalized to 100 for 1999). It hit an all-time high of 126.918 July, 2008, right before the recession savaged the economy. This cost of living index hit 127.429 in February (2011). (Click here to get the historical data – select “C-CPI-U US All Items – SUUR0000SA0”)

Chained CPI has made a full recovery from the recession

Chained CPI has made a full recovery from the recession

Source: Bureau of Labor Statistics

Melloy appropriately observes at the end of his article:

“The cost of living for Americans is now above where it was when housing prices were in a bubble, stock prices at a record, unemployment low and consumer confidence was soaring. Something has gotta give.”

It is difficult to predict how these inflationary pressures will resolve themselves – having more historical data on this index could help. But at least this small window on overall cost of living provides one more confirmation that a fear of deflation remains misplaced sentiment.