Inflation – “Headline” & “Core”

There has been a lot of discussion recently on “measures” of inflation. The popular debate usually revolves around the particular “index” which the Fed should target or use as an indicator of future inflation. Should the Fed look at “headline” inflation or at “core” inflation?

Just to give a few (of many available) examples, in a recent post Steve Williamson concludes:

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.

In a NYT op ed, Laurence Meyer, former Fed governor writes:

So in the ’70s, increases in food and gas prices affected both core and overall inflation. Some believe this is still the case today. But it isn’t. Since the inflationary era ended in the early ’80s, the Fed has earned a reputation for keeping inflation in check. For more than a decade, the markets have operated under the assumption that in the long term inflation will be stable. This means that spikes in food and energy prices do not get translated into expectations of higher inflation down the road and thus do not lead to a general increase in prices, today or tomorrow. In light of the evidence, the Fed is right to pay more attention to core inflation than to overall inflation when making decisions about interest rates.

Both Williamson and Meyer refer to a technical article available at the Federal Reserve Board, that observes:

In the 1970s and early 1980s, movements in overall prices and prices excluding food and energy prices both contained information about the trend; in recent data, the trend is best gauged by focusing solely on prices excluding food and energy prices.

Where does that leave us? The first thing to note is that inflation is not about particular prices but about the overall price level – both “headline” and “core”. Being defined as a “continuing rise in the price level”, we should expect that inflation would be characterized by very similar moves in ALL prices over a sufficiently long period of time. The figure below shows that´s exactly what happens.  Over more than 40 years, the price level, both of headline and core prices, and both either defined by the CPI or the PCE (deflator of consumption prices) have increased by similar amounts.

One characteristic of the inflation process is that it has become much less persistent. That´s an indication that inflation has been tamed. In other words, a higher inflation “today” does not indicate that inflation will also be high “tomorrow”. This characteristic is shown on the figures below – which show the autocorrelation of inflation, i.e. the degree to which inflation “today” is correlated with inflation in different points in months past – both for the CPI and PCE indices, for the period 1968 – 80 (“Great Inflation”) and for the years after 1992.

The “key” to the discussion about if the Fed should “ignore” “headline” inflation is, as found by the Federal Reserve Board article cited above, that over the past two decades the trend is better gauged by “core” prices. This is visually clear in the following pictures.

We observe that for both the CPI and PCE indices, the “taming” of inflation means there´s no more “trend” to inflation, i.e. headline price changes are mostly “noise” and therefore should not “guide” monetary policy.

As an addendum, I submit that the crisis has shown that “targeting” inflation is not ideal. First there´s the problem of choice of index – and a case can be made that the steep drop in nominal spending after mid 2008 is due to the Fed “paying attention” to “headline” inflation. Second, the fact that inflation was tamed was not due to central banks “targeting” inflation. In fact, many countries, the US included, experienced “price stability” even with without being a formal “inflation targeter”. The inflation AND output stability derived from the fact that nominal spending was stabilized. When nominal spending dropped steeply after mid 2008, “targeting” inflation constrains actions to take nominal spending up, as the intense debate about the “danger” of inflation, even among FOMC members, indicates.

3 thoughts on “Inflation – “Headline” & “Core”

  1. Pingback: Glenn Rudebusch on Headline Inflation «  Modeled Behavior

  2. Pingback: Headline & Core Inflation: Then and now « Economics Info

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