After over a year of expansionary fiscal policies and a loose monetary policy set by the central bank one of the questions at the forefront of people’s minds is, when will inflation become an issue? In order to prop up aggregate demand over the past two years the federal government has used many measures to prevent the housing bubble’s burst from spreading throughout the economy. With deflation as a legitimate concern fiscal measures such as TARP and the American Recovery and Reinvestment Act of 2009 were implemented. The Federal Reserve loosened monetary policy and lowered the Fed funds rate to a range of 0-0.25%. In addition the Fed has purchased over a trillion dollars of mortgage backed securities and $300 billion in U.S. Treasuries. With all of this inflationary action how will the central bank know when to raise rates and stop purchasing securities? Part of the answer lies in monitoring current inflation. When gauging inflation the Federal Reserve likes to use a core measure of the personal consumption expenditure report. This core component of consumer prices excludes volatile items such as food and energy prices and lessens the chance that the Fed will overreact to large temporary swings in prices. Frederic Mishkin a member of the Board of Governors from 2006-2008 shed some light on why the Fed focuses its attention on using a core measure in a speech he gave in 2007 titled Headline versus Core Inflation in the Conduct of Monetary Policy.
Does it make sense for a central bank to concentrate on core inflation? After all, households almost daily pay for energy and food items–which are excluded from the most prominent measures of core inflation–when they fill up their cars at gas stations or visit a grocery store. Households, particularly less-affluent households, spend a major portion of their budgets on food and energy. A focus on core inflation, which excludes these items, might be viewed as indicating that monetary policy makers are out of touch with what consumers really care about. Wouldn’t it be better for monetary policy authorities to focus on headline inflation so that they include food and energy in their monitoring of consumer price inflation?
As I will argue, this is not an either-or decision. It does indeed make sense for central banks to emphasize headline inflation when determining the appropriate stance of monetary policy over the medium run, but policymakers also are right to emphasize core inflation when deciding how to adjust policy from meeting to meeting. Why? Because what central bankers are truly concerned with–both for the purposes of internal deliberations and for communications with the public–is the underlying rate of inflation going forward, and core inflation can be a useful proxy for that rate. Thus, focusing on core inflation can help prevent a central bank from responding too strongly to transitory movements in inflation.
The Dallas Fed goes one step further in attempting to smooth out volatile consumer prices by calculating a trimmed mean of personal consumption expenditures. In its calculation the Dallas Fed trims 24 percent of the weight from the lower tail and 31 percent of the weight in the upper tail reasoning that “those proportions have been chosen, based on historical data, to give the best fit between the trimmed mean inflation rate and proxies for the true core PCE inflation rate. The resulting inflation measure has been shown to outperform the more conventional “excluding food and energy” measure as a gauge of core inflation.”