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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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August 28, 2006


Crabbing About Core

The Bank of England's Charles Bean had some negative things to say about core inflation at this year's edition of the Kansas City Fed's annual Jackson Hole thinkfest -- comments duly noted by Daniel Gross, by Mark Thoma, and by Michael Kowlaski -- but he was not the only one taking potshots at the core concept this weekend.  William Safire -- the New York Times' wordsmithing maven -- had some complaints of his own:   

The man whose words are parsed more closely than anybody else’s in the world opined in early June to a bunch of bankers that this year’s “core inflation” — setting aside volatile food and gas prices — “has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability.”

So said Ben Bernanke, current chairman of the Federal Reserve, in a written sentence that he must have sweated over for a week. I think his point was that inflation may be getting too high (in which case it would be inconsistent with price stability), and so I ran his words past Floyd Norris of The Times, a practiced Fedspeak cryptologist. “What bugged me most about the sentence is its reliance on ‘core’ inflation,” noted my colleague. “Using the core figure for very short periods of a few months may make sense as a way to avoid meaningless volatility, but using it for six months or even longer is hard to understand.”

Even harder to understand is why economists have picked up a vogue word in politics — every “power base” now boasts a “core constituency” — and are using it to modify “inflation.” It is a word with beautiful poetic associations, from Shakespeare’s “I will wear him in my heart’s core, ay, in my heart of heart” to Keats’s “A virgin purest lipp’d, yet in the lore/Of love deep learned to the red heart’s core.” Now here it is qualifying the rising cost of living. “The ‘core inflation’ rate,” Norris says, “is relevant for those who neither eat nor use energy.”

I don't know about that poetry stuff, but in conflating "core" with "cost of living", I think Mr. Safire gets exactly the wrong idea.  My colleague Mike Bryan explains it this way:

In theory, cost-of-living changes are measured by envisioning the cost of attaining a certain level of welfare and comparing that cost in different places or different periods of time. Unfortunately, “welfare” is impossible to quantify and a more practical approach is to calculate the cost of a representative market basket of goods and services and compare that cost between two places (like Cleveland and New York) or two periods of time (like 1960 and today)...

Many of the problems identified with the CPI (and other similar market basket approaches) have been well known to economists for nearly a century. Most arise because the basket of goods and services used to compute the cost-of-living statistic gradually becomes dissimilar to the basket of goods and services actually purchased by consumers... But another problem is that market basket statistics also pick up inflation because they measure the money cost of the basket. That is, the CPI can rise even if the cost of living is constant if the Federal Reserve continues to oversupply money and makes the dollar an increasingly inflated measure of cost.

Price statistics that attempt to isolate the persistent rise in the general price level are commonly called core (or underlying) inflation statistics...

An alternative procedure for measuring core inflation is to reconstruct the market basket in a way that reduces the influence of transitory price fluctuations originating in various components of the index. The idea here is that although such price swings may reflect changes in the cost of living, they are not part of a persistent rise in the general price level that comes from a monetary source. The best-known core inflation statistic excludes food and energy goods from the consumer market basket...

... By excluding some components of the market basket, the measure no longer reflects consumer spending patterns and therefore fails to qualify, in a meaningful sense, as a cost-of-living statistic; volatile or not, food and energy are important to our cost of living.

But it may be a useful signal of the underlying rate of change in the purchasing power of money, which -- speaking for myself -- seems like just the right idea.

UPDATE: Greg Mankiw opines:

This is yet another reason to think that for the foreseeable future the Bernanke Fed's commitment to inflation targeting is likely to be vague and informal. Monetary policy will remain more discretionary than rule-based.

August 28, 2006 in Federal Reserve and Monetary Policy , Inflation | Permalink

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Comments

The Fed should focus exclusively on a combination of commodity and asset price inflation. By the time iflation is picked up by the core rate, bubbles and rampant speculation have already inflicted severe and destructive disequilibria in the economy. The current mess created by Greenspan is the best example. The crash of the Japanese asset bubble is another. The 70's inflation was another.

I cannot think of one inflationary binge that wasn't led by a speculative surge in commodities prices followed by a bubble in equities or housing or both. The Fed is the cause of this one and failed to respond until it was too late.

The core rate is an insensitive lagging indicator that promotes speculation, market manipulation, bubbles, and inflation.

Posted by: blam | August 28, 2006 at 10:33 PM

I really don't understand people like Floyd Norris who think that the Fed should worry about the price of oil and food. Oil prices have risen because of rising global demand, not because the Fed is printing money.

Does Mr. Norris think that the Fed should _raise_ interest rates in order order to reduce inflation? That would surely bring on a 1980-style recession.

The Fed is letting inflation run high in order to "grease the wheels" of this relative prices shift, no?

Posted by: Andy | August 29, 2006 at 10:24 AM

Is quantifying welfare MORE impossible than eliminating the subjective decision-making integral to our market-basket methodology?
The problem is we've micro-massaged the process until it's lost all relevance. I accept K. Abraham's input to the Boskin Hearings: it could also be argued that cpi was underrepresented by a full point. (That would place cpi a full 2 points higher than where it is today!)
Personally, I'd welcome ANY inflation measurement that would correlate to a representative population sampling.

Posted by: bailey | August 29, 2006 at 11:05 AM

«In theory, cost-of-living changes are measured by envisioning the cost of attaining a certain level of welfare and comparing that cost in different places or different periods of time.»

That's complete bullshit. Perhaps in the theory used by prevaricators and dissemblers.

The CPI is called the Consumer Price Index for a good reason, not the Consumer Welfare Index.

And it is used to do Cost Of Living Adjustments whose purpose is not to maintain the ''welfare'' of low and middle income families, but their relative purchasing power.

The distinction is very important, because otherwise prevaricators and dissemblers have free reign with disingenuous techniques like hedonic adjustments.

Consider the case of a car: you can purchase today a much better car than in 1985, for a somewhat higher price. Does this mean that, as it would be in ''welfare'' terms, car price inflation has been negative? Not at all: because you cannot purchase today a new 1985 car for smaller price than in 1985. What you can purchase is a much better car of the same class for a higher price, so there has been car price inflation.

And that the CPI used for COLAS is means to measure relative purchasing power is the right thing. Overall the purpose of COLAs is to prevent price feedback loops; because without COLAs various categories would negotiate higher salaries to compensate for perceived falls in their relative standard of living, and if everybody tries to beat inflation, then inflation can only go up (leapfrogging).

Thus purpose of COLAs, and the CPI on which they are based, is to prevent leapfrogging, not to preserve an absolute standard of welfare.

Naturally governments routinely try to trick that by ensuring that the CPI used for COLAs greatly understates rises in purchasing power, and one of the tricks used is to argue that it should really measure an absolute standard of welfare, not a relative one of purchasing power.

Posted by: Blissex | September 02, 2006 at 11:13 AM

«I cannot think of one inflationary binge that wasn't led by a speculative surge in commodities prices followed by a bubble in equities or housing or both. The Fed is the cause of this one and failed to respond until it was too late. The core rate is an insensitive lagging indicator that promotes speculation, market manipulation, bubbles, and inflation.»

Ok, and what makes you think that the *purpose* of using the core is not promoting all that stuff?

The USA have an expensive war or two running that are being financed without taxes, and there is a huge overhang of debt both in the public sector and in large segments of the private sector.

One can fix these problems either with a painful recession or with a smooth rise in inflation, while talking cautious.

Posted by: Blissex | September 02, 2006 at 11:18 AM

«Personally, I'd welcome ANY inflation measurement that would correlate to a representative population sampling.»

But that is exactly the purpose of the CPI used for COLAs! To measure the purchasing power of a representative family of wage earners (not of the whole population), so they don't have to strike merely to maintain their purchasing power, which can easily degenerate into leapfrogging.

The theory is/was that if all prices, including labor prices, are indexed to preserve purchasing powers, then it is much easier to achieve a soft landing.

And that the CPI used for COLAs has this purpose is why it has to be relative to a specific time and place and category of workers.

There is actually a rationale to exclude short term food and energy movements from the CPI used for COLAs: and it is that while food and energy prices in the short term can do down, bringing potentially down the whole CPI, COLAs can't be negative.

So the problem is not the volatility in general of food and energy prices, but that such volatility extends into negative values.

But this is an argument for adding to the CPI smoothed food/energy prices, not for ignoring them.

Posted by: Blissex | September 02, 2006 at 11:27 AM

«ensuring that the CPI used for COLAs greatly understates rises in purchasing power»

Oops, here I meant to say: ''greatly understates FALLS in purchasing power''.

Posted by: Blissex | September 02, 2006 at 06:12 PM

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