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September 20, 2005
Fiddling With "Core" As The Inflation Fires Burn?
Today's post-meeting statement from the Federal Open Market Committee takes pains to highlight the distinctions between how prices might change in the short run, versus how inflation will behave in the longer run:
Higher energy and other costs have the potential to add to inflation pressures. However, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained.
In a recent post, Barry Ritholtz expresses some skepticism about the tendency of monetary policymakers to focus on “core inflation” numbers. He is not alone with this sentiment. I have received many expressions of the same point of view, in comments left here, emails, and in casual conversation.
detect two reasons for such skepticism.The first is that we are fooling ourselves. The easy-out of looking at a (somewhat
arbitrary) subset of prices is letting the central bank sleep while the inflation embers smolder. When we wake
up, we’ll regret the fire that we didn’t put out when it was small. To that argument I can only say I don’t think it is so, and
refer you to the evidence on the underlying distribution of individual consumer
prices in my and Jim Hamilton’s earlier posts on the topic.
The second objection goes something like this: You can look at whatever you want Mr. Central Banker Wannabe, but my market basket includes those things you want leave out, and things are definitely not so peachy-keen when I fill up my tank and open my heating bill.
Well, I understand the feeling for sure, but here I want to make a distinction between peachy-keenness from the point of view of a consumer and peachy-keenness from the point of view of a policymaker. The latter is a very modest standard, and it mainly involves not doing things to the detriment of the former. That standard does not, to me, persuasively argue in favor of reacting to price jumps driven by extreme, but mostly one-shot, increases in things like energy prices.
I think a simple thought experiment helps make my position transparent. Suppose that the central bank did respond to energy price spikes in such a way that the rate of inflation did not substantially move away from its pre-spike level. Ask yourself: Would you feel any better?
I contend the answer is no. Restrictive monetary policy works by reducing the pace of at which all prices grow (including the nominal price of labor, which is to say the monetary value of your wages and salaries). It does not, as a first approximation, operate on individual prices independently.
Why do large energy-price increases bite? It’s because your energy-consumption choices are relatively inelastic in the short-run, and so the more you spend on filling up your gas tank, the less you will have to spend on something else (which may include future consumption if you respond by saving less). Ain’t no doubt about it – this development will make you worse off. To the extent that we are a net importer of energy resources, most of your neighbors will feel the same.
Note, however, that there just isn’t any way for monetary policy to help. We can lower the dollar price of gasoline, but only if we lower all other prices as well. That would include your money income, which will grow at a slower rate to reflect the fact that the dollars you are paid are retaining their value better. What hurts is the fact that the relative price of energy has increased, and decreasing the level of all prices cannot change the fact that, relatively speaking, a greater chunk of your income is being absorbed at the pump or by the utility company.
It is the job of the central bank to maintain confidence in the value of a nation's currency. That standard is not without its ambiguities, but I think the metric of a rate of inflation that does not substantially distort the individual decisions of consumers and businesses is a pretty darn good one. We look at "core inflation" because we think these sorts of measures give us the best indications of whether we are on track to meet that objective. Asking the central bank to do more than that is not only unrealistic -- it is dangerous.
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