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The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.


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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.

I generally 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.

UPDATE: Although I characterized energy demand as relatively inelastic for purposes of my example, do see James Hamilton's remarks on exactly that point (hat tip, Knowledge Problem).

September 20, 2005 in Federal Reserve and Monetary Policy , Inflation | Permalink

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Comments


Some of the hedonistic adjustments are quite misleading.

How can I buy less of a PC or house?
That they have more features or facilities does not allow me to settle for less of those things at a lower price.And similarly the cost of health insurance. The "inelasticity" part applies here, but is adjusted away.

Posted by: K | September 20, 2005 at 08:27 PM

>>>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.<<

The last ten years have been a whole series of "extreme, but mostly one-shot, increases." It's the same game businesses play when they report their GAAP earnings in small print, and broadcast their "pro forma" earnings, with all the "one time" charges stripped out.

Posted by: GRL | September 20, 2005 at 10:10 PM

Imagine a boat full of passengers at sea one night, with a single bright light viewable in the distance. An economist passenger declares reassuringly, "the light is from a lighthouse - if I exclude the boat's recent movements, it's clear to me that the lighthouse (basket of goods) is stationary".

This illustrates the problem that non-economist passengers like me have with all this - I see the light moving away from this boatload of people, whereupon economists declare that this is impossible since the light is stationary.

So if it isn't *inflation* when a boat drifts away from a stationary lighthouse, what is the appropriate
economic label for this movement?

If you don't think the boat is adrift in reality, just humour me by educating me on the answer.

Posted by: RP | September 21, 2005 at 02:16 AM

"You can look at whatever you want Mr. Central Banker Wannabe, but my market basket includes those things you want leave out"

Yes, well, over here in Spain I have this thrown at me just about every other day by my partner, who insists inflation is much higher than the official numbers: I point out that she grumbles about this when we go to a restaurant, bar, cinema or greengrocers, but fails to do the opposite when we get a dvd player, car battery or new shoes. Our appreciation of what is happening is very asymmetric.

"So if it isn't *inflation* when a boat drifts away from a stationary lighthouse, what is the appropriate economic label for this movement?"

Well don't you notice a huge difference in the *quality* of the products you are using on a daily basis as compared with ten years ago (say). Any index number approach has to get to grips with that (even in housing). And obviously the pace of change is increasing.

So obviously you notice that the gasoline, the coffee and the cabbage are costing more, but what you maybe don't notice is that they play a smaller part in your total expenditure.

Curious detail: I drink less coffee since I spend more time on the internet, not the other way round. I don't have the same tendency to fall asleep that I used to have in the library, or on the sofa.

Posted by: edward | September 21, 2005 at 03:30 AM

"Some of the hedonistic adjustments are quite misleading.

How can I buy less of a PC or house?"

Surely this isn't a problem of hedonics. This would exist in any event with an index number system.

"That they have more features or facilities does not allow me to settle for less of those things at a lower price."

Basically instead of buying a new house you can buy a second hand one, they don't have the quality improvements you may not want.

I think 'hedonics' tends to be used as a whipping boy for everything people don't like, but the issue they address doesn't seem to be widely understood.

I don't buy the scepticism of people like Barry on the general issue, btw, since I think if the problem were a real one we should be able to identify it by going back over the numbers post hoc.

As I remember it these kinds of issues were being discussed ten years ago (whether the new economy could really run on slighly lower level of inflation), but to date no-one has been able to go back over the numbers and find a substantial problem.

It does all affect the expectations argument though, since if a majority of people *think* inflation is higher than it is, then they will expect more of the same in the future. This, at the end of the day, may be the best justification there is for yesterday's decision.

Posted by: edward | September 21, 2005 at 03:47 AM

The total basket of purchases by consumers has two elements which recently create discussion: energy and Asian imports. Notice that these two groups have opposite supply dynamics. Oil's supply is fairly inelastic, and demand is pushing up the price quickly. On the other hand, cheap Asian labor seems fairly abundant, and the cost of consumer goods seems to keep falling. Both of these groups are "volatile", but I have yet to hear the Fed's claim that we should exclude consumer goods from the price index.

In this light, I completely agree with the "pro-forma" comments made above. Perhaps it's cynical, but when people perform poorly they frequently react by wanting to change the metric.

Posted by: Keith | September 21, 2005 at 08:21 AM

One reservation that I have with the core inflation thing which is hardly alluded to in this post is the following.

Yes fresh food prices and energy prices are volatile and sort of return to mean -though in the case of energy, it does look as if the mean is not stationary ... -, but there also is a fundamental difference. Namely, energy is an essential production factor input: back in the early eighties, we were all feverishly sweating over three factor CES functions. This is why we need to worry about second round effects with energy rather than with food.

A second reservation would be that perhaps at some point in the future, someone might suggest excluding something else in the calculation of core inflation for some excellent reason, and so on, until one got to the point where the core had shrunk so much as to become meaningless to most. You then get in a situation where monetary policy goals are not shared by the public and that, many central bankers will tell you, is a time of grave danger as, perhaps, it was in the US in the early seventies.

Am I crazy or am I crazy?

Posted by: fourdegreesnorth | September 21, 2005 at 08:57 AM

Dave,

One way of looking at this is not that the Fed ignores headline inflation numbers, because of course it doesn't, but that it uses the core inflation data to gauge price movements that reflect the influence of monetary policy. The core data exclude nonmonetary events (such as the effect of weather on vegetable prices), and so better reflect the influence of the Fed’s policy decisions. Thus, in focusing on how the economy is responding to monetary policy, the Fed uses core inflation. But in focusing on how inflation is influencing economic and business decisions, it uses the headline inflation data. And it is policy’s influence on decisions that defines the policy stance.

The Fed does not appear to using the core to assess the stance of monetary policy - if it did then excluding oil and food would be harder to defend - but to assess how the economy is responding to policy. These are not the same thing, but are easily confounded, no?

Posted by: Mary Rosenbaum | September 21, 2005 at 11:52 AM

Sorry, but your argument doesn't work for me. I thought we agreed from earlier posts that inflation is an increase in money AND CREDIT relative to available goods & services leading to continued increase in general price levels. "Credit" expansion is critical to looking at our inflation problem.
I also thought we agreed that CPI measures cost of living increases, not inflation. My objections to relying upon cpi as an inflation measurement are: 1. it wasn't designed or intended for this. 2. I think housing should be a larger part of CPI (70% of families own homes & 100% of these are initially first time buyers who pay up because "housing always appreciates." 3. There are far too many subjective representations in the CPI measurement. 4. Any reliance on CPI as an inflation indicator should compare readings to those BEFORE the hedonics & substitution adjustments were enacted (these changes lowered CPI by more than a point.) 5. I see the recent oil & gas price increases as extremely inflationary & the reasons for their price increases no more plausable than those provided by Oil executives in the '70s.
I don't understand your contention that no one would want wages to fall accordingly, they haven't risen accordingly. If I'm right that inflation is under reported, the wage (gains?) we've seen over the last thirty years are even more illusory that documented.
I agree there's little the Fed can do now without inflicting pain, but the Fed is an INDEPENDENT body mandated to insure profligate Administration fiscal policies & unregulated business practices don't put our society at grave risk. This is the second time we've needed the Fed to step up to its responsibility. Under Volcker it was easy, as the populace was primed ("win" buttons, gas lines, ...) and the need for the Fed to react forcefully was obvious to all. But, this time it's different. As we've moved away from a manufacturing economy we've seen massive deregulation of financial & media sectors. One consequence is that virtually all "news" outlets regularly take business friendly positions on financial & political issues. (A lot more reporting is questioning the wisdom of FOMC ff increases than the absurdity of fiscal policy).
The Fed's our Economy's last protector. Yes, it must maintain international respect for our dollar, a job made tough by the profligacy of our current presidency. But, this is why it was formed as an independent body. It is critical that the world doesn't decide we're defining away real inflation. I agree with you that it's also a Fed responsibility to effect its mandate as painlessly as possible. Along these lines, I believe the Fed missed an opportunity by not responding to the supply shortage of ten year Treasury notes that's extended our housing price run. Jumping in to sell all the ten year treasuries the market called for just might have been the cheapest way to unwind the horrors (housing, interest rate derivative bets) we face.)
Regardless what the Fed does, we face tough times ahead. The question is, what are our prospects if the Fed doesn't do what's needed?

Posted by: bailey | September 21, 2005 at 12:57 PM

"Basically instead of buying a new house you can buy a second hand one, they don't have the quality improvements you may not want.
I think 'hedonics' tends to be used as a whipping boy for everything people don't like, but the issue they address doesn't seem to be widely understood"

Really? How easy is it to do that? Why are we not saying 'if gas costs too much, buy cheaper gas of 57 octane rating' Then there's no change in CPI.

How many 486 PCs are sold today and how much software will run on them? How many houses with single car garages are in the market? Most of the hedonic adjustements are for things which cannot be easily substituted by things of lower "hedonic" standing.

Posted by: K | September 21, 2005 at 03:40 PM

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