Thursday, October 4, 2007

Fisher on Inflation

Dallas Fed President Richard Fisher came to the defense of core inflation in a speech today on "Inflation Measurement and Price Volatility." In doing so, he comes down firmly on the (correct) side of Brad DeLong and knzn in their slap-down of Barry Ritholtz and Dan Gross, who seem convinced that core inflation is some kind of conspiracy.

It is, of course, no such thing. The real reason that food and energy are ignored in core inflation is that, according to Fisher:

It boils down to what engineers call a "signal extraction" problem; struggling to eliminate "noise" in our monthly inflation measures and trying to maximize the amount of "signal." ... By ignoring items whose price movements display significant short-run volatility, statisticians and policymakers can get a better sense of underlying trends in consumer price inflation. Because the trends change only gradually, measures that give us a better sense of what they are today provide a better sense of where overall inflation will be tomorrow. To make inflation forecasts over the next 12, 18 or 24 months, we are much better off looking at the recent behavior of a core measure ... than we are looking at the recent behavior of headline inflation.

It really is just that simple. If you're interested in the debate, or if you have any sympathy for the Ritholtz/Gross view, do read the entire speech. It's a deeply informed, yet highly readable summary, and it's only 4 pages long. Plus you'll be treated to the rare event of a Fed speaker making a (kind of funny) joke.

For a deeper treatment of how to construct inflation measures that are better at predicting future headline inflation, read Measures of Core Inflation (pdf), by Julie Smith.

Finally, if knzn is reading this, Fisher must have read your proposal to target labor costs, rather than core inflation. Looks like that's not going to happen any time soon:
[T]here are macroeconomic models suggesting that if wages are stickier than prices, a central bank would do well to focus on an index of wages rather than prices. I just can't imagine central bankers lasting very long in their jobs if they continually announced to the public their desire to hold down wage growth.

No comments: