Headline Vs. Core Inflation: We Shouldn't Have Laughed

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I'm old enough to remember the 1970s, and to remember the economic debates in the United States at the time concerning the inflation of that era. The U.S. left the Bretton Woods system near the start of the decade, thus ushering the "free float" of currencies against one another in the developed world. The U.S. economy was also the beneficiary of Paul Volcker's tough love by the end of the decade, rescuing our political class from itself.

I'm rather ashamed to remember that I was among those in that era who found the distinction between "headline inflation" and "core inflation" amusingly imbecilic, and who presumed that we amused observers were smarter or less self-serving than the distinction's promoters. But more of that point anon.

Freedom from Fear

A recent scholarly paper by Nicolas Fulli-Lemaire and Ernesto Palidda reminds us that, though the latest generation of investors is largely free of the "acute inflation fears" that gripped the generations that remember the 1970s, it still remains in the memory of institutional memory, and indeed is sufficiently powerful to drive markets.

Fulli-Lemaire is a research analyst at Amundi Asset Management in Paris. Palidda is with Credit Agricole (OTCPK:CRARF). Their article is titled "Cross-Hedging of Inflation Derivatives on Commodities."

"The buy-side of the inflation-linked market is dominated by inflation-liability-driven investors whose performances intrinsically have a structural negative inflation beta," they write. That is, these investors have to concern themselves not just with the possibility of inflation next month or next quarter, but with its possibility anywhere on a much longer time horizon.

Fulli-Lemaire and Palidda have in mind pension funds, insurance companies and other asset managers whose efforts are tied to retirement benefits. Any upward spike in inflation would be a double blow for them: it would, first, automatically amount to higher liabilities. But, more subtly, it would hurt their asset side too, negatively affecting future investment earnings.

Where Hedge Funds Fit In

In making their point about that second blow, Fulli-Lemaire and Palidda cite two recent studies by Bali, Brown and Caglayan. The first, a 2011 paper on various macroeconomic factors as a predictor of future returns, (BBC1) found that hedge funds can make good use of inflation: it is one of a set of macroeconomic risks that are positively correlated with hedge fund returns. Then the follow-up paper by the same authors, BBC2, in 2014, found that more traditional funds don't have the event-timing ability of the hedge funds, so they can't turn inflation to their advantage.

To state the point algebraically: if you can't do X, and it is important to do X, then you want to find an ally who can do X.

Fulli-Lemaire and Palidda, following up on these two papers by BBC, give three reasons why the "large institutional investors we are focusing on" cannot do what hedge funds can. Their large balances sheets are tricky to turn over, they are heavily regulated, and they have complicated, time-consuming internal deliberations. Thus, a prima facie case exists for such an institution to enter into a strategic alliance with one or more hedge funds that are free of such impediments, in the expectation that they can work the effect BBC described.

CI versus HI

This gets us back to the '70s.

I well remember the disdain with which talk of "core inflation" was greeted in the late 1970s. Everyone knew that politicians had cooked up the distinction to make themselves look better. The CI figure was generally lower than the HI figure (for most purposes that is and was the consumer price index). The "core" figure consists and consisted of HI minus food and energy. The usual joke was, "if you're thinking of living without going anywhere, staying warm, staying cool, or eating, then the CI is the important one."

But the real joke was on us. CI was important. What the statistics seemed to show in the 70s was that there was a lag between HI and CI. The lag itself seemed easy enough to understand. Energy prices were rising as a result of exogenous oil price shocks (EOPS), and these EOPS by definition impacted the HI figure first. Presumably they had a less direct impact on CI, hence the lag.

Over the course of subsequent decades, it has become clear that this wasn't really so. EOPS have virtually no impact on CI in any time frame, even as their impact on HI has increased. Thus, the relationship between HI and CI is that the latter is that to which the former will mean revert, just as the adjective "core" suggests. That makes of CI an important analytical tool, and makes all the old jokes seem, well, inadequately comprehending.

One of the animating concerns of Fulli-Lemaire and Palidda is that, although CI is the sensible figure to use in grappling with the inflationary concerns of long-term institutional investors, "there is no liquid CI-linked inflation market till date." Such investors would be well advised, then, to cross-hedge their inflation-linked derivatives with commodities, a practice that they hope will lead over time to the creation of CI based derivatives.