If economists were to look only at measures of inflation that include expenditures on food and energy, which would include their more-sensitive price fluctuations, they may be fooled into believing that general prices are rising or falling more rapidly than they really are. Having said this, measures of inflation that do incorporate food and energy prices are still useful in many circumstances and are closely followed by economists for clues to the behavior of the overall price level.
For example, economists may view the sensitive nature of food and energy prices as a symptom of future overall price increases.
Determining when to use a core inflation measure versus an overall inflation measure can be a very complicated question. Most discussions of inflation targeting recommend targeting a core inflation rate. Average increases over the entire twenty-year period shown in the Chart 1 were 3. However, the annual change in all prices, shown as the blue line, was narrow, ranging from a low of 1 percent to a high of 6 percent, while the annual changes in energy prices were much larger, ranging from a low of nearly percent to a high of nearly 24 percent.
Food and energy are significant components of overall price indexes. In December of , the general food category accounted for about Together they were about Clark, Todd E. Motley, Brian Gavin, William T. But the increases in oil prices in recent days provide another reminder that shocks can persist longer than one might have at first expected. A prolonged divergence between core and headline measures of inflation could complicate central bank communications with the public because core inflation would require some adjustment before it would provide a clear gauge of underlying inflation.
For example, the weighted median CPI inflation rate, one popular measure of core inflation, has tended to be a biased measure of headline inflation. The weighted median is exactly equal to owners' equivalent rent nearly half the time because that component has an extremely large share of the consumption basket and fairly low volatility Bryan and Pike, ; Hogan and others, ; and Bryan and Meyer, However, the productivity growth rate in residential construction is not terribly high, and so this sector is likely to have below-average productivity growth and above-average price increases.
Of course, to the extent that such a bias in a core inflation measure is stable or predictable, the central bank could easily take this into account in setting monetary policy. But even in that case, differences in average rates of inflation between the core measure and overall inflation could complicate communication with the public.
Conclusion I have argued that a measure of core inflation that is easily understood and provides some greater signal about persistent movements in inflation than does headline inflation itself is extremely valuable for the conduct of monetary policy, and that is why the Federal Reserve pays so much attention to such measures. However, I have also argued that core measures have their limitations.
A single core inflation measure cannot account for all types of shocks and can at times be misleading about what is happening to the underlying rate of overall inflation.
And if increases in headline inflation prove more persistent than initially expected, central bankers must be vigilant to ensure that they do not become embedded into expectations and thereby generate substantial second-round effects on inflation.
Finally, because price stability ultimately involves control of overall, headline inflation, which after all is the inflation measure that households really care about, central bankers should and do pay attention to headline inflation as well as to core inflation measures. A core inflation measure should not be seen as a substitute for thorough and careful analysis of the forces that are driving our economy and the inflation process.
References Aoki, Kosuke Armour, Jamie Bagliano, Fabio C. Bean, Charles Bernanke, Ben S. Blinder, Alan S. Fernandez de Lis and F. Restoy, eds. Brischetto, Andrea, and Anthony Richards Sydney: Reserve Bank of Australia, December, www. Bryan, Michael F.
Pike Cecchetti Gregory Mankiw, ed. Chicago: University of Chicago Press, pp. Meyer Cecchetti, Stephen G. Louis, Review , vol. Clark, Todd E. Clinton, Kevin Cogley, Timothy Dolmas, Jim Ottawa: Bank of Canada, January, www. Laidler, David, and Shay Aba Howe Institute, Backgrounder , vol. Macklem, Tiff Mankikar, Alan, and Jo Paisley Mishkin, Frederic S. Organisation for Economic Co-operation and Development Quah, Danny, and Shaun P.
Vahey Rich, Robert, and Charles Steindel Smith, Julie K. Woodford, Michael Princeton: Princeton University Press. The speech reflects my own views and not necessarily those of others on the Federal Open Market Committee. Return to text. These tests allow for a nonzero constant differential between headline and core inflation. The differential often turns out to be nontrivial and statistically significant.
Cogley uses published CPI over the period from Q2 to Q4 and finds that it may take about 8 quarters before there is substantial reversion of headline inflation to core inflation. Clark , using month CPI inflation from to finds little reversion over the next 12 months but about 50 percent reversion over 24 months, though that level is still statistically insignificant. In contrast, he finds substantial and statistically significant reversion at both the and month horizons using data from to These include white papers, government data, original reporting, and interviews with industry experts.
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