It’s not that headline inflation—that is inflation as reported before adjustments—doesn’t matter; but when it comes to the Federal Reserve Open Market Committee (FOMC) constructing monetary policy, the core rate of inflation (excluding food and energy prices) matters more. Or so Federal Reserve Governor Frederic S. Mishkin would have investors believe.
Unquestionably, Governor Mishkin’s position is controversial to many investors who are less than enthusiastic about such partial inflation measures. After all, they argue, it is unrealistic to modify the reported numbers to exclude any number of commonly purchased items and still calculate a viable measure of inflation. Nevertheless, in a recent speech in which he did concede some technical points on the arguments against core measures of inflation, Mr. Mishkin marshals what I consider an impressive body of evidence from central bankers and academic institutions supporting his position. In fact, I don’t believe it a stretch to summarize his remarks by stating, as far as Federal Reserve policymakers are concerned, designing monetary policy decisions solely on headline inflation is a bad idea.
The concept of core inflation measures is simple. Volatile movements in food and energy prices, though credited with creating the well-worn phrase “If you don’t eat or drive a car there is no inflation,” are characteristically transient within the general price structure. As Mr. Mishkin suggests, “Research has shown over the past 25 years or more, headline inflation in the United States has tended to revert more strongly toward core inflation than core inflation has moved toward headline inflation.”
In essence then, I suggest the argument over the use of headline or core inflation for policymaking purposes is essentially one of short-term volatility versus long-term trends. Let me explain using graphs from Mr. Mishkin’s presentation.1
The above charts illustrate the optimal level of the federal funds rate (left) necessary to fulfill the Federal Reserve’s Congressional mandate to maintain stable prices and an economic climate conducive to achieving full employment (right). Relying on a number of widely recognized econometric models, Mr. Mishkin argues the use of headline rather than core inflation (left chart dotted line) creates a “step on the gas, step on the brake” policy response, which in turn creates unnecessary fluctuations in the rate of unemployment (right chart dotted line). Thus, if I interpret Mr. Mishkin’s findings correctly, he is clearly stating that policy decisions based on core rather than headline inflation produce preferred policy responses.
Of course, none of this is meant to dismiss the informational content of headline inflation. After all, short-term distortions in volatile food and energy components can potentially turn into long-term trends.
However, if my interpretation of the timing
and content of Mr. Mishkin’s speech is accurate, the message
he delivers is that the FOMC, under the leadership of Ben S.
Bernanke, seeks an end to the debate over which measure of
inflation—headline or core—is preferable by proclaiming its
"core" belief.
1 Mishkin, Frederic S., “Headline Inflation versus Core Inflation in the Conduct of Monetary Policy,” speech given at the Business Cycles, International Transmission and Macroeconomic Policies Conference, HEC Montreal, Montreal, Canada, October 20, 2007. Available at:
http://www.fedreservespeech.gov/newsevents/speech/mishkin20071020a.htm
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