Which Inflation Target?

The consumer price index (CPI) less energy increased by 2.4% over the past 12 months, but at a 2.8% rate over the past six. Are those numbers unusually high?

As it happens, the CPI ex-energy was never as low as 2.4% before 1998 — it averaged 4.7% from 1967 to 2005. That measure of inflation dropped to 2.3% in 2002 (when the fed funds rate was 1.7%) and to 2.2% last year (when the fed funds rate was 3.2%). Aside from energy, we are still close to record lows in inflation.

The six-month pace of 2.8% could be more troublesome, if sustained. The ex-energy CPI was 2.7% or 2.8% in 1967, 1994, 1996 and 2001. The fed funds rate was between 3.9% and 4.2% in three of those years, by the way, but 5.3% in 1996.

Federal Reserve Chairman Ben Bernanke advocates varying interest rates on bank reserves (and, indirectly, their quantity) depending on some inflation target. What was not known until his speech on June 5 was precisely which measures of inflation he might focus on. His speech defined "core inflation" in the standard manner to exclude both food and energy. Surprisingly, he also highlighted capricious three-month movements multiplied by four (an annual rate).

Specifically, Bernanke noted that "at annual rates, core inflation as measured by the consumer price index excluding food and energy prices was 3.2% over the past three months and 2.8% over the past six months. For core inflation based on the price index for personal consumption expenditures, the corresponding three-month and six-month figures are 3 % and 2.3%. These are unwelcome developments."

Bernanke’s speech also described the U.S. economy as in transition to slower growth, suggesting rather ominously that "moderation of economic growth seems now to be underway." That news of slower growth and hint of higher interest rates was understandably unsettling to stock markets.

Prices of precious metals have also fallen 24% to 37% since March, which does not demonstrate any widespread impulse to hedge against inflation. It wasn’t "fear of inflation" that spooked the markets on June 5, but fear of the Fed. The Fed’s fine tuning sometimes goes awry.

The stock market rudely rallied when the May CPI came out — even though the core CPI rose at a 2.8% rate over six months and 3.8% over three months. Prices of "nondurable less food, beverages and apparel" rose at an annual rate of 38% for the three months ending in May, and energy commodities at a 91% rate, which shows why it is foolhardy to convert three months into an annual rate.

The reason for focusing on a "core" inflation rate over several months is to avoid confusing such transitory gyrations in a few prices with a sustained trend in the overall buying power of a dollar. But there are many ways of estimating "core" inflation, and one is demonstrably more informative than the two the Fed chairman picked.

Whenever anyone suggests increases in the price of energy can predict higher non-energy prices, they imply that the whole idea of leaving energy prices out of core inflation is wrong. Bernanke worried about "any tendency for increases in energy and commodity prices to become permanently embedded in core inflation."

In reality, the ex-energy CPI has always slowed significantly during the year following major spikes in energy prices. That is partly because the CPI ex-energy already embeds such major indirect effects as the impact of fuel prices on consumer transportation costs, which rose 9.8% over the past year. Yet the CPI ex-energy nonetheless remains quite tepid by historical standards.

Others have expressed concern about "asset inflation" becoming embedded in core inflation. I cannot imagine how that idea ever gained credibility. The U.S. stock market boom of 1997-2000 was not followed by higher inflation. Neither was Japan’s land and stock boom of the late 1980s. Strength in asset prices in 1929 was perhaps the world’s worst predictor of inflation.

For guiding Fed policy, I would prefer to exclude only energy prices, not food. Energy prices fell in 1986, 1998 and 2001, and the Fed cut interest rates every time. Energy prices jumped (with little change in non-energy inflation) in 1989, 2000 and 2005, and the Fed raised interest rates. Energy takes the Fed’s eyes off the ball.

A chain-weighted index, such as "the price index for personal consumption expenditures" that Bernanke mentioned, is superior to a fixed-weight index like the CPI, which overstates inflation. The fixed-weight core CPI was up 0.3% in May, for example, but the chain-weighted version was up only 0.1%.

Economists at two Federal Reserve Banks have proposed two alternative measures of core inflation — a median CPI from Cleveland and a "trimmed mean" CPI from Dallas. The trimmed mean tosses out the biggest increases and declines each month — 44% of all items in the CPI.

Todd Clark of the Kansas City Fed compared those novel price indexes with the CPI ex-energy. He found that "with a forecasting horizon of one year … only the CPI ex-energy offers statistically significant explanatory power for future inflation."

Robert Rich and Charles Steindel of the New York Fed found "the ‘standard’ ex-food and energy core measures had … a weaker connection to the trends than some of the other candidates." Compared with the median or stripped mean indexes, however, "the ex-energy measure generally maintained its better forecasting record for PCE inflation over the longer sample period."

Unless one believes the Fed should push interest rates down whenever global energy prices fall and up when energy price rise, it follows that they should focus on a price index that excludes energy. Fortuitously, a CPI or PCE deflator without energy prices also happens to be the best predictor of broader inflation trends.

Aside from direct energy costs, the U.S. inflation rate over the past six to 12 months is still as low or lower than in all but half a dozen of the past 40 years. That is no excuse to be sanguine, to be sure, but it might provide a calming antidote to recent hysterics about inflation.