Does a Decade Make Core Inflation "Transitory?"

by: Toro

I'm wading into a debate between uber-bloggers Barry Ritholtz, and Brad DeLong over core inflation.

Ritholtz argues that by focusing on core inflation, the Federal Reserve is underestimating real inflation. By focusing on the core rate as opposed to the headline rate, the Fed's policies have a distortionary effect on the real economy and financial markets.

DeLong argues that core inflation is the proper measure since the food and energy components are more volatile, making the headline consumer price index more volatile. However, even though food and energy are more volatile, the prices rise and fall around a trend. By reacting to the headline number, the Fed may be reacting to false inflationary signals in the economy.

I side with Ritholtz on this one, at least in our current environment.

This is DeLong's argument, which he posts on his web site:

If the rise in inflation is thought to be (a) transitory and thus (b) self-limiting, the Fed would prefer to let sleeping dogs lie rather than hit the economy on the head with a brick.

The Fed cannot, however, just say "we regard this rise in inflation as (a) transitory and thus (b) self-limiting, and so are going to let sleeping dogs lie." A Fed that does that quickly loses its credibility as an inflation-fighter, and a modern central bank with no inflation-fighting credibility is in a world of hurt.

However, when increases in inflation are confined to (i) energy and (ii) food prices, odds are that the increase is transitory and will be self-limiting. [Emphasis added] Hence the concept of "core inflation." If the Federal Reserve concludes that the current rise in inflation is transitory and self-limiting, it can point to the core inflation number as a principled excuse for not hitting the economy on the head with a brick.

The Fed uses the concept of core inflation not because it doesn't recognize that food and energy prices are not rising, but because it doesn't want to hit the economy on the head with a brick when it isn't necessary just because it has to demonstrate that it is one tough mujer.

The argument is "odds are" increases in energy and food prices are "transitory," and that the Fed should not react to such "transitory" increases to prove it is tough on inflation.

This was a more valid argument for the previous two decades than this decade. Core inflation as the primary focus is valid when energy and food prices flatline for long periods of time. It is less valid when food and energy prices are rising, and fast.

Rising food and energy prices have certainly been the norm the past 5-10 years.

This is a graph of WTI:

Oil has risen from approximately $10 to $80 in a decade, or 800%.

This is a graph approximating the Deutsche Bank agricultural commodity index.

click to enlarge

The index is an equal weighted index of corn, soybeans, sugar and wheat. I used spot prices as they were most readily accessible, which differs from the real index, which uses futures.

Agricultural commodities have risen by about 9.5% per year since December 2002. Since November 2004, agricultural commodities have risen by 19% annualized.

The odds are, in fact, that these increases are not "transitory." Month to month, they may be, but not when the increases stretch over years, or even decades.

Yet, when oil was hitting record highs, the Fed was emphasizing that readings on core inflation had improved in its last Fed meeting statement. And by cutting 50 bps, the Fed clearly signaled that headline inflation takes a back seat to financial market gyrations.

We do not know where commodity prices will level out at over time. Maybe it will be lower, or maybe it will be higher. All I know is that there weren't many economists (or experts for that matter), predicting $80 oil a decade ago, nor $4 corn and $9 wheat a few years back

By emphasizing core inflation in a time of high commodity inflation, the Fed is encouraging both the mis-allocation of resources in the economy, and the erosion of savings.