On the evening of May 18 James Bullard, President of the St Louis Fed and FOMC voting member, made a speech to the “Money Marketeers of New York University” titled: Measuring Inflation: The Core is Rotten. From the introduction:
In my remarks tonight I will argue that many of the old arguments in favor of a focus on core inflation have become rotten over the years. It is time to drop the emphasis on core inflation as a meaningful way to interpret the inflation process in the U.S. One immediate benefit of dropping the emphasis on core inflation would be to reconnect the Fed with households and businesses who know price changes when they see them. With trips to the gas station and the grocery store being some of the most frequent shopping experiences for many Americans, it is hardly helpful for Fed credibility to appear to exclude all those prices from consideration in the formation of monetary policy.
In critiquing the “volatility argument” for core inflation Bullard says:
Recent experience offers something to ponder in this regard. While many think that the recent financial crisis provides an illustration of the merits of the focus on core inflation, I do not see it that way at all. During the second half of 2008 and into 2009, headline inflation measured from one year earlier fell dramatically and in fact moved into negative territory. This was a signal—one among many, to be sure—that a dramatic shock was impacting the U.S. economy. Inflation was not immune to this shock. The FOMC reacted appropriately with an aggressive easing of monetary policy. Yet the movements in core inflation during this chilling period were far more muted and sent much less of a signal that action was required.
That´s interesting, because one of the reasons for the steep fall in headline inflation in the second half of 2008 was the tight monetary policy the Fed had adopted since late 2007 to counteract the rise in oil and commodities. And contrary to what Bullard argues, the Fed did not react with an aggressive easing of monetary policy, because it was exactly beginning in the second half of 2008 that nominal spending plunged to an extent not experienced since the 1930´s! Clearly, the level of the Fed Funds rate is a very imprecise indicator of the stance of monetary policy. In his dismissal of the “relative price” argument, Bullard states:
The key relative price changes in today’s global economy are for energy and other commodities. Crude oil prices, in particular, are substantially higher in real terms than they were a decade ago and constitute a significant fraction of global expenditure. It is often asserted that energy prices cannot increase indefinitely; that a one-time rise in energy prices only temporarily contributes to inflation; and therefore that it makes sense to ignore such changes. However, the logic of relative prices suggests that if households are forced to spend more on energy consumption, then they have to spend less on the consumption of all other goods, thereby putting downward pressure on all other prices (and all other expenditure shares) in the economy. Ignoring energy prices would then understate the true inflation rate, as one would be focusing only on the prices facing downward pressure because of changing relative prices.
What stands out is the fact that during the “Great Inflation” of the 1970,s, the “sticky components” became unstuck! That´s what we mean by inflation: a continuing rise in all prices. The following figure shows that it is hard to distinguish between the sticky Headline CPI depicted in the previous graph and the Core CPI.
What transpires is that a relative price change can take place within an inflationary process like during the 1970´s or not, like during the last decade. Over the last several months we´ve been hearing all sorts of arguments for and against targeting headline inflation. That should give us pause regarding inflation targeting because if even policy makers cannot agree on the appropriate target, something is definitely wrong with the concept (maybe it´s “rotten”).
I believe that disagreement provides the most compelling case for a change in target. It turns out that a nominal spending target can explain both the rising inflation of the 1970´s as well as the stable and low inflation after the mid 1980´s up to 2007. It also explains why the “Great Moderation” was lost beginning in 2008.
In the next picture, the rising inflation of the 1970´s is the result of the increasing nominal spending trend followed by the Burns Fed to accommodate the rise in energy and commodity prices. If Burns had acted differently and adopted a contractionary monetary policy in the face of those shocks, he would have imparted a decline in nominal spending, exactly what Bernanke did in 2008! So much for Bullard´s suggestion of targeting headline inflation.
Maybe it’s time to seriously discuss the nominal spending target proposals that have been put forth by different researchers, including Mankiw, Hall and McCallum in addition to Scott Sumner and David Beckworth, over the last 25 years.