Mishkin on Core vs Headline Inflation

Fed Governor Frederic Mishkin gave a speech yesterday on "Headline versus Core Inflation in the Conduct of Monetary Policy." In it, he laid out the best sound-bite argument I've yet heard for focusing on core inflation rather than headline: "Responding to headline inflation is inappropriate because it generates extensive variability in the unemployment rate." He runs through a detailed example to make the point:

Because the point about headline inflation is so important, I would like to illustrate it further with simulations of FRB/US, the model of the U.S. economy created and maintained by the staff at the Federal Reserve Board. To keep the experiments as clean as possible, I assume that the economy begins at full employment and with both headline and core inflation at desired levels. The economy is then assumed to experience a shock that raises the world price of oil about $30 per barrel over two years; the shock is assumed to slowly dissipate thereafter. In each of two scenarios, a Taylor rule is assumed to govern the response of the federal funds rate; the only difference between the two is that in one scenario the funds rate responds to core PCE inflation, while in the other it responds to headline PCE inflation. Figure 2 illustrates the results of these two scenarios:

The federal funds rate jumps higher and faster when the central bank responds to headline inflation rather than to core inflation, as would be expected (top-left panel). Likewise, responding to headline inflation pushes the unemployment rate markedly higher than otherwise in the early going (top-right panel), and produces an inflation rate that is slightly lower than otherwise, whether measured by core or headline indexes (bottom panels). More important, even for a shock as persistent as this one, the policy response under headline inflation has to be unwound in the sense that the federal funds rate must drop substantially below baseline once the first-round effects of the shock drop out of the inflation data. Responding to headline inflation is therefore inappropriate because it generates extensive variability in the unemployment rate--variability that is much more subdued when policy responds to core inflation.

This is a much more effectively way of communicating to the public why the Fed should focus on core inflation. I hope going forward they work on refining this line of line of reasoning. Maybe then mentions of core inflation won't be associated with ignorant jokes about economists who neither eat nor drive.

Recommended Reading on Inflation Measures

The Inflation Update, by Stephen G. Cecchetti
October 16, 2007

A Reconciliation between the Consumer Price Index and the Personal Consumption Expenditures Price Index (pdf),
by Clinton P. McCully, Brian C. Moyer, and Kenneth J. Stewart
Bureau of Economic Analysis Working Papers
September 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.