Friday, September 15, 2006

rotten "core" rate / inflation

U.S. Inflation Measure May Be Rotten at the Core

Sept. 15 (Bloomberg) -- U.S. policy makers have long defended the practice of using a core inflation measure as a check on how they're doing. The public, of course, sees this as just another gimmick the government uses to pull the wool over its eyes.

The concept of stripping out historically volatile food and energy prices from inflation indexes is ``an issue of trying to forecast more effectively the overall inflation rate,'' Federal Reserve Chairman Ben Bernanke explained in the Q&A following an Aug. 31 speech in Greenville, South Carolina.

A second reason for targeting core inflation ``has to do with policy making,'' he said. In order to offset the immediate effect of an increase in energy prices, the Fed would have to ``force down wages and other prices quite dramatically to keep the overall price level from rising,'' he said. The alternative is to allow ``first-round effects to pass through'' and try to ensure that the energy-price spike doesn't pass through to other prices and wages.

It sounds nice, but when you think about it, it doesn't make sense. Taken at face value, Bernanke is saying the Fed would be happy to see inflation rise as long as the core rate doesn't budge from its comfort zone. Huh?

In order to offset the immediate effect of a rise in energy prices, the Fed wouldn't have to do anything. The price of something else would fall, all things equal, as consumers adapt to the constraints on their budgets (paying more for gas means less money for other goods).

Long Lag

If oil prices go up -- a relative price change -- and the consumer price index goes up, it means that the central bank didn't allow the price of something else to fall. The price level goes up. That's inflation.

You might counter by saying that the price of something else will fall with a lag, not simultaneously; that when gas prices go up the consumer doesn't immediately cut back on his non-oil purchases.

Let's go to the video tape. The consumer price index was running at about 2 percent year-over-year during the deflation scare in the middle of 2003. Crude oil prices were hovering near $30 a barrel.

Three years later, with crude oil prices hitting a record $78.40 in July, the CPI was rising 4.1 percent. In all that time, the price of something else should have fallen to offset the higher oil prices. The fact that it didn't means our friendly central bank was accommodating the oil-price increase, printing enough money to prevent that from happening.

For the record, the core inflation rate has almost doubled to 2.7 percent in July from 1.5 percent three years earlier.


Recently some soft but solid voices have started to challenge the Fed's choice of a core index, in part because oil prices have been ``volatile'' in one direction -- up -- for most of the last three years.

Stephen Cecchetti, professor of economics and finance at Brandeis University's International Business School in Waltham, Massachusetts, and a former research director at the New York Fed, thinks the core is an unreliable guide.

``Since the goal of policy makers is stable prices overall, including those of food and energy, they should turn their attention to forecasts of headline inflation and stop focusing on core measures,'' Cecchetti wrote in a Sept. 12 op-ed in the Financial Times.

Core inflation has been running consistently below overall inflation for the past decade by about one-half percentage point, he said. The source of the discrepancy is ``in the relative price of energy that has been persistent,'' he said in an e-mail exchange earlier this week. ``Surely, the central bank's objective should not be a biased measure of medium-term inflation.''

Two-Way Street

Most inflation-targeting central banks, such as the Bank of England and European Central Bank, target overall inflation. The BOE's chief economist, Charles Bean, was critical of using core inflation measures in comments delivered at the Kansas City Fed's annual symposium last month in Jackson Hole, Wyoming.

Bean, who was the discussant on a paper by Harvard University economist Ken Rogoff, pointed out that ``globalization represents a shock to relative, not absolute prices.''

In other words, all those cheap, made-in-China consumer- goods imports are not the source of the low inflation of the last decade. ``What happens to the general price level depends on what monetary policy makers then decide to do,'' Bean said.

Bravo, Charlie!

Wait, it gets better.

``The fact that the rise in oil prices is the flip side of the globalization shock to me renders highly suspect the practice of focusing on measures of core inflation that strip out energy prices while retaining the falling goods prices,'' he said.

Reality Check

Globalization has created not only new producers but also new consumers. Each group affects relative prices; the central bank is entrusted with stabilizing the price level.

Low inflation isn't the result of a series of exogenous shocks. (How did Zimbabwe miss out?) Higher oil prices aren't the cause of higher inflation. Inflation is always and everywhere a monetary phenomenon and therefore the responsibility of the central bank.

Former New York City Mayor Ed Koch used to ask his constituents, ``How am I doing?'' In politics, there is plenty of room for subjectivity. For the Fed, the answer shouldn't depend on a flexible yardstick.

dazu noch



Anonymous Anonymous said...

> If oil prices go up -- a relative price change -- and the consumer price index goes up, it means that the central bank didn't allow the price of something else to fall. The price level goes up. That's inflation.

This is a false argument. There are two flaws in it:

1) It assumes there is zero savings. If there are savings, prices for an inelastic good rising (such as gas) will in large part simply siphon off of savings, not require sacrificing other consumption.

2) It is not clear that prices will actually fall due to a substitution effect even if the savings rate is zero (or negative). Imagine the economy consists of only two goods/services: restaurants and gasoline. Assume gas gets more expensive, so everyone must scale back on consumption. Then according to the quoted argument, restaurant prices must "deflate" precisely the amount to counter-act the increase in gas prices. But restaurants don't have a lot of pricing power; margins are slim. So even though demand is very elastic in this area, prices cannot respond to lower demand in a downwards direction. So what would be more likely is that restaurant prices won't drop significantly over all, and instead a large number of them will simply go out of business.

The CPI does not, to my knowledge, measure this effect. And I don't see why it should: there will never be just one metric of economic well-being.

This is not to say I don't think the CPI or core-CPI is deeply flawed; I do. But the reason given above is not why.

1:35 PM  
Blogger jmf said...

thanks for helping


10:50 PM  

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