Summary:
Mark Gertler warns against Fed targeting of headline inflation. Points out that core inflation has remained steady and low. Rapid increases in the relative prices of energy and food cannot go on indefinitely. Once this process dies down, as long as core inflation remains anchored, headline inflation must converge to it. Fed has adjusted monetary policy to sustain the core measure at a steady, low rate, and headline inflation is still well below that of stagflationary 70s. Impact of increasing inflation expectations, despite moving upwards, has yet to show up in the behaviour of core prices and wages. There are signs that forces that have pushed headline above core inflation are beginning to reverse due to laws of supply and demand. Funneling core inflation through a tight oscillating path even over the medium term is beyond a central bank's capability and may wreak havoc on the real economy. Monetary tightening is needed, however, in many emerging economies. A policy response from the Fed is needed that recognises the complexities of the inflationary process. Learn lesson from Japan. (Published: 28/07/08)
Notes:
- startling jump in US consumer price inflation over past several months
- entering inflationary spiral like in 70s?
- careful inspection of underlying mechanics shows that
- almost all the increase in headline CPI inflation is due to rocketing energy and food prices
- inflation excluding energy and food is significantly lower
- core CPI was just 2.4% over past year
- just over Fed's comfort zone of 1-2%
- uptick last month due to feeding through of food and energy costs to core prices
- but: over coming year, below-capacity output growth and softening oil and commodity prices are likely to push core inflation back towards comfort zone
- distinction between headline and core inflation important
- sustained move of headline inflation to levels of 70s is unlikely without an accompanying increase in core component
- reason: although they can be highly persistent, rapid increases in the relative prices of energy and food cannot go on indefinitely
- once this process dies down, as long as core inflation remains anchored, headline inflation must converge to it
- e.g. late 1960s to late 1970s
- Fed lost control over core inflation
- increased nearly in lock-step with overall inflation
- this decade
- Fed has adjusted monetary policy to sustain the core measure at a steady, low rate
- despite prolonged periods of departure of headline inflation from core
- but gaps typically under 100 basis points annually
- headline inflation indeed uncomfortably in 3-4% range recently
- but: is well below that of the stagflationary 70s
- signs that forces that have pushed headline above core inflation are beginning to reverse
- oil prices declined >10% over past several weeks
- commodity prices have softened also
- laws of supply and demand suggest this may not be a transitory phenomenon
- root cause of increase in energy and food prices was most probably rising global demand
- global economic activity expected to slow down considerably
- demand for oil and commodities is likely to weaken along with it
- will place downward pressure on relative prices of these goods
- targeting headline inflation directly will not help
- in environment of gyrating energy and food prices inflation, targeting headline inflation requires the central bank to engineer offsetting changes in the path of core inflation
- but: prices of most core items adjust only sluggishly
- funneling core inflation through a tight oscillating path even over the medium term beyond a central bank's capability
- simply too much uncertainty over both the timing and the overall impact of its interest rates moves on core inflation to believe that a central bank could smoothly accomplish this task
- sharp interest rate adjustments likely to accompany this attempted fine-tuning exercise could wreak havoc on the real economy
- is high headline inflation unmooring inflation expectations?
- would lead us back to the 70s
- some measures of inflation expectations are edging upwards
- needs to be taken seriously
- but: impact of increasing inflation expectations has yet to show up in the behaviour of core prices and wages
- core inflation has remained stable
- growth in nominal unit labour costs also remains benign
- is what most pricing of core items is based on
- Fed's reputation for keeping core inflation stable may have kept the expectation relevant for price- and wage-setting in line
- also: to date, wage-setters appear to understand that, however unfortunate, the relative increase in energy and food prices is something beyond the central bank's control
- something they must live with
- many emerging countries: picture different
- above-capacity output growth has pushed core inflation up along with headline
- also: high output growth among these economies has been an important factor in the global commodity price boom
- here monetary policy needs tightening
- inflation is a real concern
- but: policy response is needed that recognises the complexities of the inflationary process
- including its global nature
- not simple knee-jerk reaction!
- lesson from Japan
- a fractured credit system can induce prolonged stagnation, even in an advanced economy
- given uncertain conditions of the US financial and real sectors, goal should be to achieve price stability in a way that continues to keep low the possibility that this economy could suffer a similar fate
