Monday, 21 April 2008

Elevated US headline inflation proves persistent

The latest numbers on consumer prices in the United States indicate that inflation looks relatively contained, especially so-called core inflation excluding food and energy. However, the Federal Reserve's focus on core inflation over the past few years may actually have resulted in it leaving too much inflation on the table.

On 16 April, the US Labor Department reported that the consumer price index (CPI) rose 0.3 percent in March. This followed an unchanged reading in February. The energy index was a major contributor, rising 1.9 percent in March after declining 0.5 percent in February. Excluding food and energy, consumer prices rose 0.2 percent in March after having been unchanged in February.

Compared to the year-ago level, the headline CPI rose 4.0 percent in March, the same as in February. The so-called core CPI excluding food and energy rose 2.4 percent in March, up from 2.3 percent in February.

The Labor Department report shows that inflation, while no longer accelerating, remains somewhat elevated, with the CPI excluding food and energy even showing a slight uptick in the year-on-year rate of increase.

Other measures of core consumer price inflation monitored by the Federal Reserve Bank of Cleveland show even higher levels of core inflation than the traditional core index. The following table from the Cleveland Fed shows the recent monthly percentage changes in its 16-percent trimmed-mean CPI and median CPI in addition to the traditional CPI measures from the Labor Department.

CPI less food & energy0.
16% trimmed-mean CPI0.
Median CPI0.

The next table, showing the percentage changes in these indicators over the last 12 months, makes it more apparent that headline inflation has been, and remains, higher than measures of core inflation, with inflation excluding food and energy showing the smallest rate of increase.

CPI less food & energy2.
16% trimmed-mean CPI2.
Median CPI3.

Elsewhere, inflation showed varying trends. Among the other major developed economies releasing inflation figures last week, Canada reported a dip in inflation, consumer prices rising just 1.4 percent in March compared to a year ago, less than the 1.8 percent increase in the previous month. In the UK, the annual rate for March was unchanged from February at 2.5 percent. In the euro area, though, inflation accelerated, consumer prices jumping 1.0 percent in March to bring the annual inflation rate to 3.6 percent from 3.3 percent in February.

The diverging trends are reflected in the respective central bank stances. The European Central Bank (ECB) has continued to express concern about inflation, stubbornly resisting calls to cut interest rates, or even to move to an easing bias. In contrast, the Federal Reserve, the Bank of England and the Bank of Canada have all cut interest rates recently.

The contrast between the Federal Reserve and ECB actions so far is all the more remarkable when one considers that the reported headline inflation rate of 4.0 percent in the US remains above the 3.6 percent rate in the euro area.

However, we all know that the Federal Reserve focuses on the core inflation rate -- specifically, inflation excluding food and energy -- rather than the headline inflation rate, and the former has been consistently lower than the latter in recent years. The reason for the focus on the core rate is that Federal Reserve officials consider the headline number too volatile, often reflecting temporary supply shocks, and that the core rate better reflects the underlying inflation rate.

In contrast, the ECB does not explicitly monitor a core inflation rate as it does not assume that such a rate, especially one that specifically excludes food and energy, is necessarily a better reflection of the underlying inflation rate. Instead, it looks at a wide range of indicators to determine longer-term inflation trends.

Would the Federal Reserve be well-advised to de-emphasise the core inflation rate, specifically inflation excluding food and energy?

The headline CPI started to diverge in earnest from the measures of core CPI -- especially the CPI less food and energy -- from 2003 onwards. While the headline CPI has indeed been more volatile than the core indicators, it has fluctuated around a very apparent trend line, a line that clearly reflects a high trend rate of increase. In contrast, the most widely-used measure of core CPI in the US, the CPI less food and energy, has consistently shown the slowest rate of increase.

In other words, the elevated headline inflation has been persistent. With the prices of crude oil and other commodities continuing to rise in recent weeks, it is likely to remain so.

After five full years of divergence between the headline inflation rate and the inflation rate excluding food and energy, it must surely be time for the Federal Reserve to start to question whether the latter really is a better reflection of underlying inflation, as it has insisted, and whether the Federal Reserve might not be better off to emulate the ECB and just focus on headline inflation instead.

Strictly speaking, the Federal Reserve does not actually use the CPI as a gauge of inflation but rather the personal consumption expenditures (PCE) price index, but this fact provides no solace. PCE inflation excluding food and energy has also consistently lagged overall PCE inflation.

What has caused prices excluding food and energy to lag overall prices?

Many economists attribute this phenomenon to globalisation and the rapid industrialisation of emerging economies, especially China. On the one hand, the sharp rise in the supply of labour available from emerging economies has allowed manufactured goods to become cheaper, lowering the inflation rate of prices outside of food and energy. On the other hand, it has raised the prices of commodities such as food and oil, where the increase in demand has outstripped the increase in supply.

Therefore, insofar as the increasing availability of cheap manufactured goods and rising demand for commodities are the result of the reintegration of emerging economies like China into the global economy and may prove to be long-term trends, reliance by a central bank on an inflation rate that excludes just food and energy may result in the underlying inflation trend being underestimated and allow an unintended inflationary bias to be introduced into monetary policy.

Having said that, the focus on the inflation rate excluding food and energy does confer an advantage in inflation-fighting by focussing attention on a lower rate. This could help lower inflation expectations.

However, it also carries a risk. The continued focus on a so-called core rate in the presence of a persistently and obviously higher headline rate could damage the credibility of the Federal Reserve and be interpreted as a sign that it is unable or unwilling to accurately report and fight inflation. This would raise inflation expectations.

The risk of inflation expectations getting unanchored is one that the Federal Reserve may not be able to afford to ignore. With Federal Reserve officials already expressing commitment to combating downside risks to growth, it may not be able to withstand further assaults on its inflation-fighting credentials.

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