ECON430-Topic #3: Inflation is on the rise! Or is it?

Inflation is on the rise! Or is it? We often hear of the difference between core inflation and headline inflation, but we also have a number of different measures of inflation. The consumer price index inflation (CPI), the producer price index (PPI), and the personal consumption expenditure index (PCE) are all used to measure inflation. Which one does the Fed focus on and why? Are the other inflation measures useful or just noise? For example, the PCE index showed 1.6% inflation for the year ending August 2011.

Minneapolis Fed President Narayana Kocherlakota recently questioned whether or not the FOMC’s inflation target was on the rise. Worries about unhinging inflation expectations are not new. As far back as February 2009 (and probably further) some economists were predicting that inflation expectations were on the rise (it is also interesting to note the unemployment and growth projections out of the FOMC back in October 2008… Lehman month). Others (such as Goldman Sachs economists) are questioning whether the Fed should even consider targeting inflation, but rather look at nominal GDP targeting instead.

Questions to consider:

  • What should the Fed target? CPI? PCE? PPI? Core? Headline? Hemline? What are the advantages of each? (The hemline is a joke… but there is such a thing called the hemline indicator)
  • What would the Fed do today if they were targeting nominal GDP instead. What would this imply? Do you think the Fed could achieve that goal? What might stand in the Fed’s way?


10 thoughts on “ECON430-Topic #3: Inflation is on the rise! Or is it?”

  1. The Federal Reserve should focus on headline inflation in my opinion. The headline consumer price index reading gives the most accurate representation of all the items a household would purchase on a regular basis (1). I do not think any emphasis should be given to the “core” inflation that removes food and energy prices. The grocery store and gas station are probably two of the most common reoccurring costs for the typical household; therefore to me it makes zero sense to disregard these items when measuring the prices for consumers (2).
    The consumer’s expectations for inflation will have a significant impact on the Fed’s ability to keep inflation under control (3). So far this year headline CPI has remained stable, increasing 0.4% and 0.3% in August and September respectively. This remains roughly in line with the average yearly inflation over the past 10 years of 2.1% (3). With the less than satisfactory jobs picture, and considering recent inflation readings, it appears that consumer expectations for inflation do remain stable for the medium term outlook. As the economy rebounds but interest rates remain low, as the Fed as pledged to do so for an extended period of time, a lot of the Feds credibility should fall on its effectiveness in controlling headline inflation.


  2. Inflation is certainly on the rise as the growth in the money supply continues to outpace the economy. This is very problematic for the middle class; inflation deteriorates the value of wealth and savings which has the effect of lowering the rate of return on hard work. Rising prices in a market economy results from monetized budget deficits. True economic growth brings down the price level, increases in production and productivity pushes prices down and living standards up.

    The best way to measure inflation using the ways mentioned above is the headline consumer price index. The core consumer price index is a sham when it comes to an accurate level of inflation. The exclusion of food and energy in the measurement of the rate of inflation in the economy is equivalent to examining somebody’s health but excluding their circulatory system. Just look at how expensive commodities have become over the past decade, the price of oil is nearly 10 times more expensive than it was 10 years ago.

    In addition, the headline consumer price index is up 3.9% year-over-year.(1) The price level will double every 18 years at an annual growth rate of prices at 3.9%. It would be difficult to convince the 25 million people who are unemployed or underemployed that inflation is nonexistent or not a problem. Also, there are some economists who believe the consumer price index understates the rate of inflation by at least one percentage point, making the situation even worse for those of us with low to moderate incomes. (2)



  3. The old standby inflation indicator CPI has some significant shortcomings, and has long been criticized particularly for its inability to account for substitutions among goods as relative prices change. Failure to account for this “substitution bias” causes many to question the CPI’s legitimacy as an accurate measure of inflation affecting consumer goods. The Personal Consumption Expenditure Index (PCE) is a similar measure to the CPI but contains a few tweaks which allow it to account for substitution among goods and ultimately allows it to provide a more accurate view of consumer goods’ inflation.

    Though CPI price level rose by 3.9% in the year ending in August 2011, the PCE rose by only 1.6% in the same period, suggesting that consumers were able to find ways to substitute away from goods (like gasoline) whose prices rose relatively quickly over the past year. Perhaps more Americans took the bus, walked, or carpooled to work than previously before. If a certain year saw astronomical inflation in a certain category (say, tropical fruit, due to severe weather events in Florida), and the CPI correspondingly rose to 5%, would the Fed have cause to tighten policy? Clearly not–a look at the PCE would quickly allay any fears of economywide inflation, and the Fed would be able to set policy based on the economy’s actual needs. Because of its ability to avoid the distortionary effects of localized price fluctuations, the PCE provides a far more stable and accurate indicator on which the Fed can base monetary policy.

  4. I think the Fed should continue using the core inflation as its measurement for inflation. Since core inflation is used to forecast future inflation based upon the core measures which they are more accurate than prediction based upon total inflation. It is a good idea for the core inflation to exempt food and energy in that it avoids the short run movements due to supply shocks and hence it gives the clear picture of the long run inflation rate faced by the households. It is also the good thing to exclude energy which is influenced by forces outside the US. According to Larry Meyer comments he said, “The Fed has built credibility over the last two decades: Long-term inflation expectations are stable, have been stable for more than a decade, and are likely to remain so. This means that spikes in food and energy prices do not get translated into expectations of higher inflation down the road and, thus, do not lead to a generalized increase in prices, today or tomorrow. So the critical question is whether inflation expectations are well anchored today—we believe that they are—and, more importantly, whether they are likely to remain so…”. The study done by David (March 2011) do support the Meyers theory, David did find out that there is a strong correlation within the last and next three months of the overall inflation (see the graph from David article). With this I think the Fed should continue to use core inflation as it is in the right track since we expect the long term inflation to remain low.

    US economic brief May 31 2006 article No.5

  5. The buzz of this month on targeting nominal GDP has generated commentary from both skeptics and supporters. There are fine arguments on both sides yet the conclusion on whether it’s a good idea depends on the current nature of the economy as well as national sentiment. Right now, the Fed is not benefiting from reactions in expectations to support to its policy efforts. (Expectations have been very rigid in response.) Changing their target and thus their framing of the current economic problems might generate the confidence and expectations reactions they need to maximize policy effectiveness.
    Given that inflation is not currently very far from its ideal level, Romer [1] argues that, “a small increase in expected inflation could be helpful.” This is because it would, “lower real borrowing costs,” and reduce the debt people are struggling to pay back. This boost may then prompt the consumer spending we’ve all been hoping for and allow for real output to grow. Once there was real growth in the economy, the target for nominal GDP would restrain inflation from rising any further and moderate those expectations that might question the effect on price stability. Targeting nominal GDP shouldn’t incite much expectation for any drastic change in Fed behavior because it still promotes responsible management of inflation and GDP growth.
    The general suggestion for approaching NGDP targeting is to adopt “level targeting” (which sets a target and adjusts based on the previous period’s levels). This is helpful in moderating short and long term NGDP growth. Sumner [2] proposes limiting the Fed’s job to just setting and managing the NGDP target to allow, “the markets to determine money supply and interest rates.” He claims it would appease the current conservative critics of the Fed’s current role in “central planning” and effectively let the market support its target. He explains, “The Fed would create NGDP futures contracts and peg them at a price that would rise at 5% per year.” Then, investor expectations would allow contract purchases and sales to work like OMOs tightening and contracting the money supply based on their profit opportunities. This would allow the market to maintain the money supply and affect interest rates in a way that would achieve the NGDP target because expectations and market behavior would ensure meeting that target rate.


  6. As American economy struggles with trillions of national debt, Fed is trying to come up with ways to improve the economy. It will be a big decision to shift the Fed’s target to a nominal level of GDP. Economic researchers predict that nominal GDP target could actually improve the economy. (1)

    According to Christina Romer, first of all, targeting nominal GDP would work as a communication tool. The Fed could improve confidence and expectations of the future growth. For example, a good expectations about future growth would make a consumer more likely to spend more today. The result would be higher overall sales. Furthermore, the investors would be willing to invest in a company with high sales. This would increase investment, which is important for GDP growth. The second effect of targeting NGDP would be temporary increase in expected inflation, which is not good. However, with the short term real interest rates approaching zero, the increase in expected inflation would be helpful. As a result there will be lower real borrowing costs, which will also boost consumer spending (2).

    According to Daniel Neilson, the nominal GDP targeting will not work. He argues that household and businesses still deleverage and demand will be low until the debt is paid off (3). I support the Neilson’s opinion that nominal GDP targeting won’t work, because nominal GDP gap exists in the American economy. The gap exists, because of recession and low inflation in 2009 and 2010. In addition, Fed’s credibility has been questioned recently many times. I don’t think that big steps like targeting nominal GDP would take place.


  7. I think the Fed should target Core PCE because it is less volatile and does not commit the substitution bias. The Core PCE (Personal Consumption Expenditure) index is an inflation index that measures good and services that are pertained to individual consumers. This is different from the CPI (Consumer Price Index) which measures the change of prices between a fixed basket of goods for a household. The Core PCE also takes into account a change in preferences for goods either because of tastes or increase in prices for complements or substitutes. (1) Because the PCE takes into account the substitution effect it increases about a third less than the CPI. This lack of volatility also occurs because Core CPE does not include food and energy prices.
    The non-inclusion of food and energy prices is because food prices can be dependent on weather conditions (egg prices which are a part of non-Core PCE increased 35.6% in the past month) and energy prices (which increased 43% in the past month) are dependent on foreign countries (OPEC for oil). (2) Since these prices are so volatile it makes sense that the fed should not have them included in their target or else the fed would have to change their policy more frequently to accommodate PCE (not core).
    Expected inflation is not predicted to increase too. The Cleveland fed estimates inflation to be 1.4% over the next decade so it appears that inflation is not running rampant. (3) And with the Fed stating that they are keeping the Fed Funds Rate down at its current level till mid-2013 inflation will be kept in check.

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  8. It is possible that a solution to concerns over inflation expectations could be found in targeting nominal gross domestic product. While the idea is not new, it has been recently brought back onto the table as an option. In order to target nominal GDP, the Fed would set a goal for the rate it should grow at, most likely an annual rate of 4-5%. This rate prediction accounts for inflation around the typical 2% target and long-term prospective growth of 2-3% (1). Tools of the central bank, as well as reactions of monetary policy would remain the same as with inflation targeting: tightening when nominal GDP is expected to grow too rapidly and easing when growth is expected to be too slow.

    Those advocating for nominal GDP targeting say it would achieve greater macroeconomic stability (2). It could also help policy makers respond more effectively to supply shocks since it would be more flexible than inflation targeting (1). For example, a negative supply shock often under current targeting may lead the Fed to tighten policy resulting in an even deeper fall in output. With nominal GDP targeting, equal emphasis is placed on real GDP growth and inflation in order to balance the negative effects of the shock (2).

    A downside to nominal GDP targeting is that NGDP is not as straight-forward for people to adjust their expectations to. Concerns with deflation and a loss of trust in the Fed’s decisions may also stand in the Fed’s way (1). Nominal GDP targeting could provide more stability, but there is also the possibility that no longer targeting inflation could lead to more damaging effects. If the switch were to be made, it should be done with caution.

    2) “Nominal GDP Targeting Rules: Can They Stabilize the Economy?” by T.E. Clark

  9. I feel that the fed should more closely monitor the core inflation rate, mainly due to its exclusion of food and energy prices. Core inflation subtracts volatile food and energy prices from the CPI index. It is a good point to raise that gasoline and food do consume a large proportion of household income, and that this should be considered when measuring changes in price. But the negative effects that these prices could have on expectations in the market would be detrimental. If the fed were to base their inflation predictions solely on headline inflation, investors would view this more volatile figure to be a sign of weakness in the economy. These expectations could hurt business cycles and ultimately output. The mere fact that there is no explicit inflation target by the fed is hurting its credibility. With much of the fed’s ability to conduct effective monetary policy relying in the hands of the public’s perceived credibility, a decision should be made sooner rather than later. Controlling the public’s expectations of inflation seems to be of high importance when targeting the variable, and choosing the core inflation rate will better stabilize these expectations.

    Question to Consider:

    Should the fed place more emphasis on controlling the (already high) unemployment rate. How can they control this without making financial markets less stable?

    What role will the inflation calculation argument play in your next presidential candidate choice?




  10. In rebuttal to Lyle’s and Daniel’s comments and to add some more to Mayfredrick’s argument, my opinion is that the Fed is right in targeting core inflation when deciding their policies. The FOMC has a dual mandate of keeping inflation at 2 percent and to promote maximum employment (1). One would think that gas and food prices should be included in the overall inflation since they are a large portion of the common American household budget. But the Fed is not questioning whether people buy groceries and gas but rather is the core inflation a better measure of overall inflation than headline inflation once the overall prices have adjusted to volatile gas and food price changes. The Fed’s view is that the headline inflation of tomorrow coincides with core inflation today(2). The Fed’s aim consider headline inflation of today and tomorrow but viewing core inflation today gives them a view of what headline inflation will be in a year from now(3). Empirical studies of movements in overall prices in the 1970s and 1980s show that core inflation is a better predictor of overall inflation tomorrow(4). Using core inflation instead of headline inflation gives the Fed a heads up so that they can enact policy quicker making it more effective.

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