NEW YORK (MNI) – The following are excerpts from the remarks of St.
Louis Federal Reserve Bank President James Bullard, prepared for the
Money Marketeers of New York University Wednesday night:
Controlling overall inflation is a goal of monetary policy.
Measures of overall, or headline, inflation attempt to include changes
in the prices paid for a wide variety of goods — that is, what
households actually have to pay for their daily purchases. This is a
sensible notion of precisely what the central bank can and should
control over the medium term.
Many discussions of monetary policy, even within the central
banking community, discuss movements of subsets of prices instead of the
overall or headline measure of price changes. The most famous subset is
the core — all prices except those relating to food or energy. Core
inflation is the measured rate of increase of these prices. Control of
core inflation is not the goal of monetary policy, although it sometimes
seems to be given the amount of emphasis put on this concept in the U.S.
In my remarks tonight I will argue that many of the old arguments
in favor of a focus on core inflation have become rotten over the years.
It is time to drop the emphasis on core inflation as a meaningful way to
interpret the inflation process in the U.S.
One immediate benefit of dropping the emphasis on core inflation
would be to reconnect the Fed with households and businesses who know
price changes when they see them. With trips to the gas station and the
grocery store being some of the most frequent shopping experiences for
many Americans, it is hardly helpful for Fed credibility to appear to
exclude all those prices from consideration in the formation of monetary
policy.
—
1. The “volatility” argument
I will start with an easy one, the argument that headline inflation
is more volatile than core inflation and that, therefore, if monetary
policy reacts systematically to headline inflation the economy itself
would become more volatile. This could also be termed the “all hell
would break loose” argument. Yes, it is true that headline inflation
tends to be more volatile than subset inflation measures that exclude or
downweight the most volatile components. However, I do not think this
says anything about how policy should or should not react to movements
in headline inflation. Any policy response can of course be adjusted
appropriately to take into consideration that the price index contains a
certain level of volatility. In other words, the policy response can be
optimized given the inflation index being targeted. Some monetary policy
simulations that I have seen in this area simply take an existing policy
rule that has been designed for core inflation and use the same rule
with headline inflationresulting in increased volatility in goal
variables. That type of experiment is just saying that an inappropriate
policy rule will produce less-than-satisfactory results, which is hardly
surprising.
One might very legitimately turn the headline volatility question
on its head. With core inflation as the preferred index for monetary
policy analysis, the policymaker will tend to react to relatively small
movements in measured core inflation. In that case, arguably, any policy
response has to be larger — possibly substantially larger — when even
small changes in measured core inflation are observed in order to
execute the optimal policy. This may be ill-advised to the extent that
small movements in core inflation are in fact simply noise.
—
2. The “core predicts headline” argument
One popular argument for focusing on core inflation is that core
inflation is a good predictor of future headline inflation. I think this
is wrongheaded, as well as wrong.
Let’s begin with the wrongheaded part. The idea that core predicts
future headline is often based on univariate models of the inflation
process, that is, ones that try to predict future headline inflation
using only a single variable or a simple function of a single variable.
I do not think this is a good metric for understanding whether core or
headline is the right inflation measure on which to gauge monetary
policy decisions, regardless of whether it holds up in the data or not.
Presumably, we would want to use a fully specified model to try to
predict headline inflation, the goal variable with respect to prices, in
the U.S. The full model would include measures of expected inflation,
developments in the real economy, the stance of monetary policy
(including the implicit inflation target), and other variables to help
to predict future headline inflation outcomes. One could throw all of
these variables out in favor of a single variablecore inflationwhen
trying to predict future headline inflation, but presumably then one
would have a misspecified model of the inflation process in which a
simple function of core inflation is acting as a proxy for all the
variables that are supposed to be important for predicting future
headline inflation. In this misspecified model, a simple function of
core inflation may or may not have been a good predictor of future
headline inflation over a particular time period, but so what? I do not
think this really tells us anything about whether it is a good idea to
key policy off of core inflation or not.
—
4. Should the central bank target a subset of prices?
The last set of arguments in favor of a notion of core inflation
are far more sophisticated, but also far less established. Up to now we
have taken it for granted that the prices that households care about
include all the prices that households actually have to pay. This
suggests that our existing headline price indexes are the right ones to
look at when considering what is best for households. Yet there is some
interesting literature that asks the following question: Can we think of
a theoretical world in which the central bank would want to target a
subset of the prices faced by households, instead of all the prices, on
the grounds that this policy would be preferred by the households
themselves? We could then call changes in this subset of prices core
inflation.
The general answer is that this is indeed possible, and I believe
future research in this area has to proceed in this direction. But these
models, while interesting, are not ready for prime time, and so I think
for now the best we central bankers can do is focus on the best measures
of overall inflation we have and attempt to stabilize those.
The key feature of the literature in this area is that some prices
are considered “sticky” (in a sense made precise in the research), while
other prices are fully flexible.
—
What should we do?
The theme of tonights remarks has been that U.S. monetary policy
needs to de-emphasize core inflation. Core inflation is not the ultimate
goal of monetary policy. I have considered four classes of arguments for
a focus on core inflation and found all of them wanting. For this reason
I think the best the FOMC can do is to use headline inflation when
looking at the price side of the dual mandate.
Core versus headline inflation has been a long-standing issue for
the FOMC. The focus on core inflation in the U.S. seems to be more
entrenched than in many other countries. I have argued that the older
ideas justifying this focus have rotted over timeindeed they probably
made little sense from the start. The FOMC needs to get a better
playbook on this question so that the Committee can reconnect with
American households, who see price changes daily in many of the items
the Committee seems to exclude from consideration in making monetary
policy.
The headline measures of inflation were designed to be the best
measures of inflation available. It is difficult to get around this fact
with simple transformations of the price indexes. The Fed should respect
the construction of the price indexes as they are and accept the policy
problem it poses. To do otherwise may create the appearance of avoiding
responsibility for inflation.
There is widespread agreement that headline inflation is the goal
variable of monetary policy with respect to prices. Normally one would
want to operate directly in terms of the goal variable whenever
possible. The concept of core inflation suggests that somehow an
intermediate target strategy with respect to price inflation is optimal
for U.S. monetary policy. As I have outlined in my remarks tonight, I do
not think this has ever been convincingly demonstrated. In addition, the
U.S. focus on core inflation tends to damage Fed credibility. As I noted
in the introduction, many other central banks have solidified their
position on this question by adopting explicit, numerical inflation
targets in terms of headline inflation, thus keeping faith with their
citizens that they will work to keep headline inflation low and stable.
The Fed should do the same.
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