Tuesday, August 29, 2006

Which inflation rate?

As the FT reported a couple days ago, economist Charlie Bean raises an important question:

The US Federal Reserve is wrong to focus on core measures of inflation that exclude energy prices, Charles Bean, chief economist at the Bank of England, has suggested. It should focus instead on headline inflation, which is much higher, he argued. Including energy and food costs, US consumer price inflation is running at an annual rate of 4.1 per cent, against 2.7 per cent for core inflation.

Mr Bean told the Fed’s annual Jackson Hole symposium at the weekend that energy prices were rising for the same reason the price of many manufactured goods were falling: the rise of China and other emerging market economies. Since both price trends had a common cause, he said it makes little sense to focus “on measures of core inflation that strip out energy prices while not stripping out falling goods prices as well.”

Even though many economists endorse some form of inflation targeting, there is no consensus about how inflation is best measured for purposes of such a policy. The Fed's tradition of focusing on a consumption deflator excluding food and energy is plausible, but it is only one of many plausible choices. As far as I know, this particular choice has never been fully justified over others. Some members of the FOMC may share Charlie's judgment on this question.

The bottom line: This is yet another reason to think that for the foreseeable future the Bernanke Fed's commitment to inflation targeting is likely to be vague and informal. Monetary policy will remain more discretionary than rule-based.

Update: A reader calls to my attention an August 29 speech by Dallas Fed President Richard Fisher in which he addresses the issue:
In preparing for our deliberations at the FOMC, I have come to rely upon what is called the Trimmed-Mean PCE Deflator....The business of getting it right on inflation is not an easy task. I keep a close eye on all of the inflation measures.
This statement can be seen as further confirmation that there is no consenus on which price index to use. Until monetary policymakers settle on a price index, inflation targeting cannot possibly become the rule-based monetary policy that some people would like it to be.