The Fed Cares About Headline Inflation

By Dr. Duru written for One-Twenty

October 21, 2007


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On October 20, 2007, Governor Frederic S. Mishkin made a speech about inflation (or click here) at the Business Cycles, International Transmission and Macroeconomic Policies Conference in Montreal, Canada. I found it very interesting because he actually did a great job in explaining a central bank's approach to measuring, tracking, and controlling inflation. Mishkin argues that the core inflation rate, inflation minus food and energy, is a good proxy for the true underlying rate of inflation. Not only does the core inflation measure filter out short-term swings in inflation, but, more importantly, Mishkin states that monetary policy cannot control the price movements of food and energy. He gives the example of soaring food prices in the face of a drought or the present-day run in oil prices from supply and political shocks.

Mishkin notes that a convincing concentration on core inflation helps to keep a lid on the public's long-term inflation expectations: "The focus on core instead of headline inflation--and clear communication with the public about that focus--... may help anchor inflation expectations when headline inflation increases temporarily but core inflation remains essentially unchanged. If the public understands that the central bank is using core inflation in formulating monetary policy and trusts that the central bank is right to do so, the public will realize that the central bank does not need to respond aggressively to a surge in headline inflation to keep inflation under control. And, with core inflation stable, the public will be less likely to think that the central bank has weakened its commitment to a strong nominal anchor when it does not tighten monetary policy to stabilize headline inflation. The result is that inflation expectations are likely to remain anchored, which may lead to better outcomes not only on inflation but on employment as well, because the central bank will not have had to tighten monetary policy as much in response to the energy price shock."

However, Mishkin also gives a nod to headline inflation, the overall inflation rate that includes food and energy. He acknowledges that food and energy are important components of a household budget, especially for households with lower incomes, and cannot be ignored: "Because households care about the prices of all the items they buy, it clearly does not make sense to pretend that people do not eat or drive. Thus, I have no qualm in stating that controlling headline inflation, not core inflation, is--along with maintaining maximum sustainable employment--the ultimate aim of monetary policy."

If this headline inflation is more persistent and pervasive than expected, then central bankers must take it into account for monetary policy: "If the rate of change in the price of an excluded item receives a permanent shock, then the headline inflation rate can deviate from the core measure for an extended period of time. The longer this period of high headline inflation persists, the greater is the risk of second-round effects as the public begins to build this higher inflation into its expectations....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."

So, I take back all the mean things I have said about the Fed not caring about inflation, real or otherwise...at least until the next rate cut.

Be careful out there!

DR. DURU®, 2007