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Why Core Inflation?

by: Mark Thoma August 28, 2008 | about stocks: DIA / SPY / TIP    

Mark Thoma

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There is a lot of confusion over the Fed's use of core inflation as part of its policy making process. One reason for confusion is that we are using a single measure to summarize three different definitions of the term "core inflation" based upon how it is used.

First, core inflation is used to forecast future inflation. For example, this recent paper uses a "bivariate integrated moving average ... model ... that fits the data on inflation very well," and finds that the long-run trend rate of inflation "is best gauged by focusing solely on prices excluding food and energy prices." That is, this paper finds that predictions of future inflation based upon core measures are more accurate than predictions based upon total inflation.

Second, we also use the core inflation rate to measure the current trend inflation rate. Because the inflation rate we observe contains both permanent and transitory components, the precise long-run inflation rate that consumers face going forward is not observed directly, it must be estimated. When food and energy are removed to obtain a core measure, the idea is to strip away the short-run movements thereby giving a better picture of the core or long-run inflation rate faced by households. I should note, however that this is not the only nor the best way to extract the trend and the Fed also looks at other measures of the trend inflation rate that have better statistical properties. Thus while the first use of core inflation was for forecasting future inflation rates, this use of core inflation attempts to find today's trend inflation rate [There is a way to combine the first and second uses into a single conceptual framework that encompasses both, but it seemed more intuitive to keep them separate. In both cases, the idea is to find the inflation rate that consumers are likely to face in the future.]

Let me emphasize one thing. If the question is "what is today's inflation rate," the total inflation rate is the best measure. It's intended to measure the cost of living and there's no reason at all to strip anything out. It's only when we ask different questions that different measures are used.

Third, and this is the function that is ignored most often in discussions of core inflation, but to me it is the most important of the three, it is the inflation target that best stabilizes the economy (i.e. best reduces the variation in output and employment).

In theoretical models used to study monetary policy, the procedure for setting the policy rule is to find the monetary policy rule that maximizes household welfare (by minimizing variation in variables such as output, consumption, and employment). The rule will vary by model, but it usually involves a measure of output and a measure of prices, and those measures can be in levels, rates of change, or both depending upon the particular model being examined, but generally a Taylor rule type framework comes out of this process ( i.e. a rule that links the federal funds rate to measures of output and prices).

However, in the Taylor rule, the best measure of prices is usually something that looks like a core measure of inflation. Essentially, when prices are sticky, which is the most common assumption driving the interaction between policy and movements in real variables in these models, it's best to target an index that gives most of the weight to the stickiest prices (here's an explanation as to why from a post that echoes the themes here).  That is, volatile prices such as food and energy are essentially tossed out of the index.

Another feature is that the indexes often include both output and input prices, and occasionally asset prices as well. That is, a core measure of inflation composed of just output prices isn't the best thing for policymakers to target, a more general core inflation rate combining both input and output prices works better.

The core inflation rate you see in the news, the one that strips out food and energy, should be though of as a short-hand, quick measure of all three of these concepts. But in each case the Fed uses measures (formally or informally) designed to best satisfy these three functions. For example, when it forecasts future inflation, it uses a different concept of core inflation than it uses in setting policy.

The Fed paper linked above is one example of how the Fed searches for the optimal way to predict future inflation. All that matters for policy is finding the most accurate way to predict inflation, and they will use whatever definition of inflation is best suited for this job. There is evidence that core inflation is best and that's why it is used, but it is a statistical question and didn't have to come out that way (and the best measure of core inflation may not be simply stripping out food and energy - also, there are different measures of prices to choose from, e.g. the CPI and the PCE).

When it comes to setting policy, the Fed doesn't formally use a Taylor rule, though they certainly have Taylor rule estimates in the information they use when considering policy moves, instead they look at a variety of measures of inflation (both core and total), and they look at the rate of change in input prices such as wages and commodities (e.g. oil) as well. They then weight each of those pieces of information in some way (and hence construct an implicit index of all of this information), and then set the federal funds rate accordingly. While I have no way of knowing if the weights they use are optimal, this is exactly what the theoretical models say they should do. But the point is that it is some implicit combination of all of this information that matters for policy, and hence this core measure is very different from the core measure that is best at predicting future inflation alone.

The core inflation rate you see in the news, the CPI less food and energy, does do a fairly good job of representing the information the Fed uses to forecast future inflation, i.e. it is a measure of the trend rate of inflation (but not the best one), and it also does well at approximating the information the Fed will use to set policy, but the actual process it uses is more complicated than this and the Fed employs measures that are specialized for the job at hand.

Finally, there is also a question of what we mean by inflation conceptually. Does a change in relative prices, e.g. from a large increase in energy costs, that raises the cost of living substantially count as inflation, or do we require the changes to be common across all prices as would occur when the money supply is increased? Which is better for measuring the cost of living? Which is a better target for stabilizing the economy? The answers may not be the same. For a nice discussion of this topic, see this speech given yesterday by Dennis Lockhart, President of the Atlanta Fed:

Inflation Beyond the Headlines, by Dennis P. Lockhart, President, Federal Reserve Bank of Atlanta: Let me begin by posing the simple question: What do we mean by "inflation"? The answer to that simple question isn't as simple as it may seem.

The popular treatment of inflation in our sound bite society risks confusing inflation with relative price movements and the cost of living. By cost of living, I'm referring to the costs you and I incur to maintain our level of consumption of various goods and services including essential items such as food, gasoline, and lodging. 

Relative price movements occur continuously in an economy as individual prices react to market forces affecting that good or service. Neither relative price movements nor sustained high living costs constitute inflation as economists commonly use the term...

And I think I'll end with this part of his remarks:

Attempts to measure the aggregate rate of price change — no matter how sophisticated — remain imperfect. As a result, when it comes to measuring inflation, judgment is needed to distinguish persistent price movements that underlie overall inflation from the relative price adjustments. Separating the inflation signal from noise involves much uncertainty — especially when making decisions in real time. Discerning accurately the underlying trend is difficult. It is essential for those of us who have responsibility for responding to these trends to use a wide variety of core measures and inflation projections to make the most informed judgment we can.

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This article has 13 comments:

  •  
    Aug 28 06:47 AM
    Using "core" inflation ignores the fact that we all need to buy food, drive our cars, and such. The misery index will determines how much stuff we buy, the demand for better wages, the way we vote, and the price of gold. Core inflation is not sufficient to predict that. The Fed should really be abolished, as advocated by Jim Rogers, but, if it is to exist, it should look at overall inflation, not just the so-called "core" with oil and food stripped out.
    Reply
  •  
    Aug 28 07:39 AM
    'core' inflation is not a gauge for overall inflation, simply because it is subset of it and such generalisation leads to a logical fallacy.
    at the same time it is not the gdp deflatior either that could help measure impact at the production side, and it is not either the PPI.
    the 'core' is simply lower and therefore more convenient.
    Reply
  •  
    Aug 28 08:39 AM
    Yes, refined data is vital to continued good decision making. Inflation as measured by the common man occurs in the store, at the gas pump and when paying for drugs and the electric bill. It tells him the economic policy of this government has failed him and the future is not only bleak, but filled with danger. For the common man core inflation is not a joke it reminds him of an ineffective government and economic policy.
    Reply
  •  
    Aug 28 09:04 AM
    Of course it always helps when you jigger the numbers to make your supposed inflation outcomes look better.

    The numbers are supposed to give policy makers the information they need about the economy to make good decisions.

    So throwing out energy costs has had the effect of allowing imported energy to become to important to our economies success. In the microeconomic sense it is like being captured by your sole supplier of critical components

    And golly gee fed folks how hard is it to track median home costs to median income. So what could it possibly mean that the median home costs move from 2.5/3 to more than 5 times median income. (especially when your talking credit/pricing/ inflation)

    So get out of your models and your office, and walk around in the economy you are trying to manage
    Reply
  •  
    Aug 28 09:41 AM
    In my opinion the best definition of inflation is increase in money supply. That is what the "Austrian Economist" use and it was confirmed by studies of Milton Friedman. Whenever there is increase in money supply there is boud to be inflation. If you look at money supply increase over the last 20 years or so, it has been increasing a the pace of 6-7%/year. So inflation in the long-term is going to be around that number.

    There are many inflation deflators used to underestimate inflation if you use CPI as inflation indicators. For example, 1) Hedonistic adjustments
    2) Using Substitution pricing 3) using rent equivalents for housing.

    Also, many costs including medical costs, cost of college education, tuition, fees, books etc are under-represented in calculation of CPI.
    Reply
  •  
    Aug 28 09:41 AM
    Definition of Inflation: The dollar in your pocket will buy less today than yesterday, and less again tomorrow than today.
    Reply
  •  
    Aug 28 09:46 AM
    just more bs by the govt.the rate of inflation of the 5 basic daily needs is app.15-16%.the gov. doesnt want you to know that. they dont consider the shrinkage of weights & measures that go along with the price increases.i think the dumb-dumber americans are finally beginning to wake up to the mess this gov. created.it may be too late.
    Reply
  •  
    Aug 28 10:12 AM
    The basic problem with the way inflation is "measured" and used by policy makers is that discretionary items are over emphasized and items for which there is less discretion (energy, food and health care) are under emphasized. This is convenient for simplifying policy decisions and possibly valid for viewing projections of the distant future (this second point may be debatable), but it does little to give a realistic view of current conditions and how demand in the near future will be affected.

    The current CPI and PPI measurements are in fact a sham if the goal is to manage economic issues over a time frame of one to a few years.
    Reply
  •  
    Aug 28 12:36 PM
    In theoretical models used to study monetary policy, the procedure for setting the policy rule is to find the monetary policy rule that maximizes household welfare (by minimizing variation in variables such as output, consumption, and employment).

    This is highly variable depending on the household characteristics (average or stratified sample) which is assumed as the driver for maximizations. In the end we are given an estimate and most of the world fails to realize just how sketchy the results are. The Fed knows and that is why they are not do dogmatic about policy.
    Reply
  •  
    Aug 28 01:11 PM
    The US CPI is produced by the US Bureau of Labor Statistics, which uses the CPI to base increases to government wages and pensions. Its in their invested interest to fudge the numbers and keep the CPI as low as possible.

    Even the "seasonally adjustments" they use have increased in the last year to make inflation seem a lot lower than reality. Real inflation is probably 8-10% now. Welcome back to the late 70's people.
    Reply
  •  
    Aug 29 12:57 AM
    zooey, but which household's welfare is being maximised? The one that borrows heavily and spends freely, or the one that earns and saves? There is no level of inflation that will benefit both. The moment you offer the cop-out of "aggregated" or "majority", you are biasing the entire system toward greater borrowing, less saving, and higher inflation, because everyone's incentives will be aligned in that direction.
    Reply
  •  
    Aug 29 03:15 PM
    Why is it that when financial assets (e.g. residences) increase in value, they are said to "appreciate" rather than "inflate". Conversely, when then decrease in price (but not in value to the homeowner), they are said to depreciate rather than deflate?

    If all the deflation in realestate (housing) was factored into the "inflation" mix (of increased prices for essential services/goods), would we essentially be experiencing "stag-flation&quo... inflation or deflation?
    Reply
  •  
    Sep 02 08:05 PM
    Only a highly-biased liberal economist like Thoma could argue for the merits of a useless stat like core inflation. Both CPI (core and non-core) as well as GDP are highly skewed to give the desired result. They are certainly of no value to investors or traders... (See Perfecting the Art of Mass Deception at tradesystemguru.com/co... )
    Governments throughout history have clearly demonstrated that their motivation in producing (and manipulating) these statistics has little to do with providing any useful information and everything to do with getting re-elected. Rely on them at your peril.
    Reply
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