Barry Ritholtz Does Not Seem to Understand the Purpose of "Core Inflation"

The Federal Reserve's mandate to maintain price stability requires that whenever significant inflation threatens it is supposed to hit the economy on the head with a brick: raise interest rates, and so discourage investment spending, lower capacity utilization, raise unemployment, and so create excess supply. The Federal Reserve would rather not do this unless it has no other option. If the rise in inflation is thought to be (a) transitory and thus (b) self-limiting, the Fed would prefer to let sleeping dogs lie rather than hit the economy on the head with a brick.

The Fed cannot, however, just say "we regard this rise in inflation as (a) transitory and thus (b) self-limiting, and so are going to let sleeping dogs lie." A Fed that does that quickly loses its credibility as an inflation-fighter, and a modern central bank with no inflation-fighting credibility is in a world of hurt.

However, when increases in inflation are confined to (i) energy and (ii) food prices, odds are that the increase is transitory and will be self-limiting. Hence the concept of "core inflation." If the Federal Reserve concludes that the current rise in inflation is transitory and self-limiting, it can point to the core inflation number as a principled excuse for not hitting the economy on the head with a brick.

The Fed uses the concept of core inflation not because it doesn't recognize that food and energy prices are not rising, but because it doesn't want to hit the economy on the head with a brick when it isn't necessary just because it has to demonstrate that it is one tough mujer.

Here is Barry:

The Big Picture | There's No Inflation (If You Ignore Facts): One of our favorite topics -- inflation ex-inflation -- has been slowly creeping into the mainstream. We have been hammering away on this for years; the surprise half point cut by the Fed is the most likely reason as to why the MSM seems to have discovered this meme. Here's the latest from Dan Gross' Contrary Indicator column in Newsweek:

"Readings on core inflation have improved modestly this year," the Federal Open Market Committee said in justifying its 50-basis-point interest-rate cut last month, while conceding that "some inflation risks remain."

Catch that bit about "core inflation"? That's Fedspeak for: inflation is under control, unless you look at the costs of things that are going up. The core rate excludes the prices of food and energy, which can be volatile from month to month. Factor them in, and inflation is about as moderate as Newt Gingrich. In the first eight months of 2007, the consumer price index—the main gauge of inflation—rose at a 3.7 percent annual rate. That's more than 50 percent higher than the mild 2.3 percent core rate. The prices of energy and food are soaring, at 12.7 percent and 5.6 percent annual rates, respectively, and have been doing so for years. As a result, the CPI—including food and energy—has risen 12.6 percent since July 2003, for a compound rate of about 3 percent.

Signs of inflation are evident throughout the economy. When investors fear a rising inflationary tide, they latch onto the driftwood of gold. The day Bernanke cut rates, the price of the precious metal soared to heights not seen since 1980, when inflation ran at nearly 12 percent! I read about this in The Wall Street Journal (whose newsstand price rose 50 percent in July), which I picked up in the lobby of a New York hotel (where the average nightly rate soared 12.5 percent in the first seven months of 2007 from 2006, according to PKF Consulting) while sipping on a Starbucks Frappuccino (whose price has risen twice since last October)."

The whole article is worth your time to read . . .

Comments

[Barry Ritholtz]

Price increases in food and energy have been transitory and self-limiting ?

PUH-LEEZE.

Over the past 5 years, we have heard this emphasis on the Core levels.

Over that same time period, Oil has risen from ~$15 to over $80 (Gee, that doesn't sound either transitory or self limiting); Food prices have risen nearly as much, with beef, Dairy and grains all up tremendously. (Milk and cheese have nearly doubled over the past 12 months).

Outside of the absurdist core, BLS has not done a very good job capturing the increases in Health care costs, Housing or Education.

Look, if you want to pull out one month as aberrational (i.e., Nat Gas post-Katrina) that's fine. But to ignore a multi year trend where "volatility" is essentially in one direction is to accept an analytical misdirection that only serves to obscure Reality.

Ever since the Fed dropped rates to 1%, the dollar's purchasing power has fallen, nearly every asset class denominated in dollars has soared, and Inflation has risen dramatically.

Except in the core. Inflation ex-inflation, prices are stable.

No thanks.

[Idaho_Spud]

The government has a great deal of incentive to understate inflation - COLA adjustments to SS recipients and the government sector chief among them. If the Fed so desired, there are any number of smoothing techniques that can take into account a Katrina, a refinery fire, or an Exxon Valdez event.

So... I guess the real question is: Should monetary policy be set so as to protect a large number of poor, lower middle class, and fixed income people (whose food and energy useage consume a large portion of their income)?

Or should monetary policy be set to protect entities who are encouraged to access to the discount window?

[dblwyod]

Actually you both have a point - so what does the data tell us ? If you look back over the last couple/few decades the DeLong position is vindicated. Total CPI is very noisy but is transient and both converges on and swings around the core. However recently there's been a divergence between core and total - more interestingly if you look at it a couple of ways, say YOY% changes and changes since a beginning recent trends in both appear benign; at least up to this last report. However total CPI has sustained an increase significantly above core.
Rather than continue to verbally arm-wave you can see the charts here: http://tinyurl.com/327bdt.

There's another point to make when you look at the sustained charts - over the years PPI and CPI converge and move together w/o major differences. Looking at the sustained changes chart you can that PPI has grown increasingly above CPI for several years.

So the questions are: does the worldwide pressure on energy, and as it ripples thru to food, mean we're seeing a structural change ? Think so.
Does that mean that the dangers of inflation creeping back in are rising. Think so.
What does the faster rising inputs prices mean for profits and overall economic performance if it's not being passed on to the buyer ? This is left as an exercise for the student. Extra-credit for also exploring how China' shift from exporting deflation to exporting inflation will accelerate that process.

[dblwyod]

Oops sorry about that. Turns out tinyurl's expire quicker than I thought. Try
1. http://tinyurl.com/327bdt for first in-depth pass and
2. http://tinyurl.com/2anlj6 for some refresh and other sources.