PRINTMarket Update -- Economic Comment
July 11, 2007
A hot topic of late is whether or not the Fed should be targeting overall inflation rather than core inflation, as has been their long-standing practice. Since we all consume quite a bit of food and energy–roughly 14% of the CPI is comprised of food items, while another 9% is made up of energy goods–it seems illogical to ignore these key items.
The truth of the matter is that the Fed does not ignore headline inflation. In fact, the Fed, in practice, pays close attention to all inflation measures ranging from the GDP price deflator (the broadest measure of inflation) to the various individual components of consumers' consumption baskets. The Fed also draws on anecdotal evidence of inflation–making use of their extensive business contacts–and runs a variety of models to help them forecast inflation. In short, the Fed tries not to leave any stone unturned when searching for signs of general–as opposed to relative–price increases.
The reason the Fed emphasis core consumer inflation in their public statements and forecasts is because food and energy prices are volatile, and this volatility can whipsaw inflation forecasts and misguide policy. Moreover, the Fed believes that monetary policy is not an effective tool for influencing commodities prices. That said the Fed carefully watches inflation expectations for signs that consumers are starting to react to higher relative prices, whether they be food, energy, shelter or some other component of the basket. Thus, even if the Fed does not appear to be emphasizing changes in overall inflation, their emphasis on inflation expectations serves as a catch-all for all sources of inflation. Should inflation expectations shift noticeably, a temporary increase could become permanent. The Fed will be quick to react in such situations.
The Bernanke Fed spends a lot of time talking about inflation expectations. Similarly, there have been a number of influential economic research papers on the subject. The commonly held view is that inflation expectations are highly influential in determining the level of inflation. Indeed, many attribute the decline in inflation in recent decades to the anchoring of inflation expectations. Quite simply, if inflation expectations are anchored, then consumers will not change their purchasing habits in reaction to shifts in prices. There will be no sudden rush to buy ahead of an expected price increase, a behavior that encourages inflation to persist. (Witness the price spiral that occurred in the home prices once home price inflation expectations became unmoored.)
The reason the Fed spends a lot of time talking about the need to keep inflation and inflation expectations anchored is because they need to constantly remind the public that they are in control. If the public doubts this notion for an instant, inflation expectations could shift, which in turn, could feed inflation. Quit simply, the Fed needs to guard their credibility...at all times. Thus, the fact that there are media stories questioning the Fed's preference for core measures of inflation when "we all have to eat and drive" will probably evoke a response from the Fed for no other reason than to alleviate any public concern over this issue. Fed to public, "Don't worry, we are on it.".
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