Sunday, April 10, 2011

Core Inflation

A widely-held view, reflected in recent FOMC statements and statements on policy by various Fed officials, is that, in fulfilling the price-stabilization element of the Fed's mandate, the Fed should focus on a core price index that omits the most volatile prices. There are various ways to construct core price indices, including dropping food and energy prices, the Cleveland Fed's median CPI measure, the Dallas Fed's trimmed mean price index, and the Atlanta Fed's sticky price index. There are basically two arguments here.

The first argument, represented in this this piece by Laurence Meyer is purely statistical. The Fed should pay no attention to food and energy prices, as movements in these prices tend to be transitory. Further, in recent data, as supported by this study for example, core inflation tends to predict headline inflation, so if we want to control headline inflation, ultimately we should be controlling core inflation anyway.

The second argument in favor of using core inflation measures, comes from New Keynesian (NK) theory. In NK models, welfare losses arise from relative price distortions, but the problem arises only for the sticky prices, not for the more-volatile flexible prices. Therefore, according to the argument, monetary policy should confine attention to only the sticky prices, for example what is in the Atlanta Fed's sticky price index.

Now, this speech by Charles Plosser got me thinking, in particular this passage:
Some fear that the strong rise in commodity and energy prices will lead to a more general sustained inflation. Yet, at the end of the day, such price shocks don’t create sustained inflation, monetary policy does. If we look back to the lessons of the 1970s, we see that it is not the price of oil that caused the Great Inflation, but a monetary policy stance that was too accommodative. In an attempt to cushion the economy from the effects of higher oil prices, accommodative policy allowed the large increase in oil prices to be passed along in the form of general increases in prices, or greater inflation. As people and firms lost confidence that the central bank would keep inflation low, they began to expect higher inflation and those expectations influenced their decisions, making it that much harder to reverse the rise. Thus, it was accommodative monetary policy in response to high oil prices that caused the rise in general inflation, not the high oil prices per se. As much as we may wish it to be so, easing monetary policy cannot eliminate the real adjustments that businesses and households must make in the face of rising oil or commodity prices. These are lessons that we cannot forget.
There is an interesting idea in here. In general, which prices are volatile and which are not will depend on the monetary policy regime and what the central bank is attempting to target.

To make the argument more precise (though it's still pretty rough - just a sketch really), I need some symbols, which I can't put in the body of this post, so I'll direct you to these notes. Here's the basic idea. Suppose that all prices are flexible, and that the Fed can control the price level, but only imprecisely due to errors related to measurement, the loose link between policy and prices, or even sheer stupidity. Suppose that there are essentially two kinds of goods, "volatile-price" goods, and "smooth-price" goods, with the relative price of these two types of goods fluctuating randomly.

Now, suppose the Fed chooses to target the price of the smooth-price goods, in dollars. As a result, the prices of volatile-price goods are indeed volatile, both due to policy errors and because of the relative price variability. As well, the prices of smooth-price goods, which are indeed smooth, are an excellent tool for forecasting the future price level, as fluctuations around the price level target are due only to current innovations coming from policy errors and innovations to relative prices.

But, the Fed could choose instead to target the prices of volatile-price goods. Then, everything is turned on its head. The volatile prices are now smooth, the smooth prices are volatile, and the good forecasting tool for the future price level is the volatile price.

But, if you are a firm believer in sticky prices, you will now say: "But if the Fed attempted to target the non-sticky prices, we would have a problem, in that we would get inefficient fluctuations in real GDP. Further, the Bils and Klenow data, and Klenow-Malin work tell us something important about the stickiness of prices across goods and services." To which my reply is: "This evidence tells us only about the observed behavior of particular prices, and tells us nothing about how the pricing behavior depends on monetary policy. For that, we need a theory, and perhaps a structural model of price-setting that we can fit to the data. Indeed, I think I (or someone else) could write down a model with flexible prices where, under particular monetary regimes, the model delivers the features of the data. Indeed, this paper, by Head/Liu/Menzio/Wright does something like that."

To say how a central bank should be responding to particular observed price movements, we need some solid theory concerning the welfare effects of inflation, how monetary policy affects inflation, and some solid measurement to tell us about the quantitative effects. I don't see anything solid that justifies the Fed's focus on core inflation measures. Indeed, one could, I think, make a better case for looking at headline inflation measures.


  1. Interesting point. The gold standard would be an example to illustrate your point. "Amazing how sticky the price of gold was in the olden days!"

    But might data from the gold standard be also a way to test the extent to which the definition of core inflation is policy-invariant? (If the data are good enough).

    Or, maybe we could try different frequencies too. If prices that were sticky/flexible on weekly or monthly data also turned out to be sticky/flexible on annual data?

  2. Nick,

    Often people think about this issue in terms of variability in interest rates vs. money. For example, in the National Banking era in the US, short-term nominal interest rates were highly variable (including seasonally). From 1914 on, short-term nominal interest rates are smooth and money is variable. When a central bank targets something, something else has to give, and that applies to prices too. I think it's the key to figuring out whether prices are sticky in a way that matters. You're thinking about some candidates for natural experiments and, as you say, the only question is whether the data is any good.

  3. Stephen:

    Chris Haynes and John James has an interesting AER paper where they look at whether there is downward nominal wage stickiness in a non-inflationary regime. They specifically look at the U.S. 19th century where there was secular deflation at times. They find no evidence of downward nominal wage stickiness. One implication of their finding is that nominal wage stickiness is conditional upon the monetary regime.

    This paper raises questions about famous Akerloff et al. (1996) that claims downward nominal rigidity is a fundamental preference of workers. The Hanes-James paper suggests that the current downward nominal wage stickiness may simply be a function of our inflationary-biased monetary policy regime.

    Here is a link to the paper:

  4. David,

    Thanks for the reference. Yes, a standard argument that I heard last year when worry was spreading about the possibility of deflation in the US, was essentially the Akerlof story.

  5. there is a Borio paper which questions the assumption of downward nominal rigidity in wages, based on historical evidence. reference to follow.

  6. Steve
    I link to a post I did commenting yours

  7. Joao,

    You seem to have misunderstood. I'm not saying that inflation targeting is a bad thing, I'm questioning the conventional focus by central bankers and others on core inflation measures.

  8. Steve
    I surmized that from your discussion "IT is bad" was implied! If no one knows which "inflation" to target"...

  9. I'd make an inverse "stickiness" hierarchy: Headline Inflation > Core Inflation > Wage Inflation. You could argue that the inflation spiral cannot get started unless somehow headline inflation "propagates" down to wage inflation. Supply shocks are going to have much more of an effect on headline inflation, oil and food being the best examples. Aggregate demand and demand for labor will have more to do with wage inflation. Monetary policy is supposed to be able to have an effect on aggregate demand - so unless policy allows for wage growth, seems the spiral can't get started just by high commodity prices.

  10. This post got me looking at different data series on FRED. It's interesting how CPI less food and energy disengaged from the CPI in general:

    Mr. Plosser's quote:

    "If we look back to the lessons of the 1970s, we see that it is not the price of oil that caused the Great Inflation, but a monetary policy stance that was too accommodative."

    But is that what we see?

    Just eyeballing this, doesn't it suggest an accommodating monetary policy in the face of a sustained disinflation? Inflation was declining, so "oil did it" seems to have been a rational conclusion on the part of the Fed, as well as the assumption that unemployment could be dealt with through monetary policy now that the supply shock was over. As soon as that disinflation seemed to stop, the Fed Funds rate started increasing.

    This sloppier graph seems to express the idea even better:

    They could have rationally attributed the discontinuation of the disinflation to occasional spikes in the price of oil from the '76 to '78 period. After that, when inflation started increasing in a manner that couldn't clearly or initially be attributed to oil - especially with no obvious supply shock increase in unemployment - the Fed responded accordingly be increasing the Fed Funds rate.

    Regardless of what the actual Fed targets were at that point - aggregate targeting, whatever - looking at it through a Fed Funds lens, it doesn't seem all that bad an attempted pursuit of the dual mandate to my undergraduate eyes.

  11. Whoops - didn't html-ize those links. Cut and paste if you care to see if what I was getting at was worthwhile. Cheers.

  12. I think it would help you to go back and read some of the accounts of the policy discussion from the mid to late 1970s, and into the Volcker era. I don't have references off the top of my head, but maybe some other readers know where to look.

  13. That would be deeply appreciated. Google Scholar searches leave one swamped.

  14. This piece by Robert Hetzel is one of the best and very readable account of the "mindset" of monetary policy makers in the 1970´s:

  15. Joao,

    Thanks, I should have thought of this. Hetzel is an excellent student of the period and the policy debates.

  16. you could just read the fed transcripts.