The Great Inflation Debate


From an economist's point of view, the "core" rate counts more than the "headline." But the Fed will have to pay attention to both

If there's one thing Americans don't like, it's a cheater. And as far as many people are concerned, it's cheating to calculate the rate of inflation by deliberately excluding soaring food and energy prices. After all, the logic goes, we all have to pay for food and energy, so why ignore it when measuring inflation? Is this some kind of conspiracy to ignore the plight of the poor or to make the economy look healthier than it really is?

Actually, there are two strong arguments for ignoring food and energy prices in setting monetary policy. Even if you don't agree with them, it's probably a good idea to understand what they are—if only to prepare yourself for the next barbershop debate over why everything's so expensive these days.

The debate over "headlline" inflation (which includes everything) and "core" inflation (which excludes food and energy) heated up on June 13 after the Bureau of Labor Statistics reported a 0.6% increase in May in the headline rate but only a 0.2% increase in the core rate, seasonally adjusted. Over the past three months, headline prices have grown at a 4.9% annual rate, while core prices have risen at an annual rate of just 1.8%.

If you care about the headline rate, inflation looks nasty, but if you focus on the core, it seems benign. So this is a debate that matters.

Core Vs. Headline Rates

The first argument in favor of the core rate is that it tells the Federal Reserve more about what it really wants to know: the inflationary pressures within the U.S. economy. Oil and food prices tend to zoom up and down (mostly up lately) because of factors that have nothing to do with underlying conditions, such as the recent flooding of Midwest croplands or armed conflict in Nigeria's oil-producing region. Those factors come and go, so it would be a mistake for the Fed to jerk interest rates up and down in reaction to them. The Fed shouldn't start raising rates to squelch inflation until it works its way into the core rate, which is heavily affected by longer-lasting factors like workers' wage demands.

Some economists acknowledge the headline rate is too volatile for the short run but is still the one to focus on in the long run. After all, they say, if gasoline has gone from around $1 a gallon in 1998 to around $4 now, that's real money, not a trivial fluctuation. Ditto for other things that have soared in price, from milk to meat.

But "core" believers have a response to that argument as well. They say that an obsession with headline inflation could cause the Fed to raise interest rates too much in reaction to some isolated price increase. Take oil as an example. If the price of oil goes up because of some bad thing that happens in the real world, there's no escaping the pain. No matter what the Federal Reserve does about monetary policy, Americans' standard of living will have to suffer. Like it or not, the only thing the Fed can do is influence how that pain gets felt.

Let's say the Fed decided to focus on keeping headline inflation under control despite a runup in oil prices, as many people seem to advocate. With imported oil prices going up, the only way the Fed could hold the line on headline inflation would be by decreasing the price of everything else in the consumer market basket. That would be immensely painful because prices don't adjust downward nearly as readily as they adjust upward. Example: When's the last time you heard of anyone accepting a pay cut to save the company money? In practice, lowering the price of the non-oil market basket would require a punishing recession.

Core Values

There is a gentler alternative, and it's the one that believers in core inflation advocate. They say the Fed should let the price of oil rise and just try to keep the prices of everything else on their normal, slightly upward trajectory. Americans would still feel pain because they would have to spend less on other things to make room in their budget for more spending on oil (or actually gasoline, which comes from oil). But at least they wouldn't have to suffer through a recession.

Marvin Goodfriend, a specialist in monetary theory at Carnegie Mellon University, is one of those who believes the core rate of inflation is what really matters. "In the world economy, what's getting scarce are commodities, food, and fuel. We need to allow those prices to rise to reflect true scarcity. That has nothing to do with monetary policy," says Goodfriend, adding: "In the U.S., we will have a reduction in the standard of living because of this."

Unfortunately, Goodfriend and others acknowledge, the Federal Reserve can only get away with focusing on the core rate of inflation if it can somehow persuade the general public to do the same. That's a tall order. If ordinary Americans see high headline inflation because of costly oil, their first instinct is to demand higher pay to compensate for it. In other words, they try to insulate themselves from the pain instead of gritting their teeth and accepting that more expensive oil will necessarily reduce their standard of living. Ultimately, the strategy of seeking higher pay to compensate for higher prices at the pump can't work, says Goodfriend, but it's human nature.

Fed officials are well aware of the core theory of Goodfriend and others, but they're also aware of the practical difficulty—impossibility?—of getting Americans to focus on the core rate instead of the headline rate. Practically speaking, then, Fed leaders will end up paying attention to both, and straining to retain Americans' confidence that the Fed won't let persistently high inflation creep back into the economy.

Coy is BusinessWeek's Economics editor.

Steve Ballmer, Power Forward
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