Is Bernanke Out of Touch on Inflation?

When it sets interest rates, the Federal Reserve naturally looks at trends in inflation, among other things. However, instead of focusing on headline CPI, which includes all items in the economy, the central bank looks at core CPI instead -- a measurement that excludes food and energy. With gas and food prices galloping ahead of other items' costs, is the Fed making monetary policy based on the wrong set of data -- one that understates the loss in the dollar's purchasing power due to inflation?

Food and energy are outrunning the rest
The following table illustrates the difference between inflation for food and energy, and inflation for all other items:

Segment

12-Month % Change at April 2011*

CPI – All items less food and energy (Core)

1.3%

Energy

19%

Food

3.2%

CPI – All Items (Headline)

3.2%

*Unadjusted. Source: Bureau of Labor Statistics.

Leading blue-chip companies provide plenty more anecdotal evidence regarding the impact of commodity price increases:

  • Last week, the CFO of the world's largest retailer, Wal-Mart (NYSE: WMT  ) , said the company was raising prices on a number of grocery items, including meat and dairy. Higher gas prices also reduce the foot traffic in Walmart stores.
  • In April, the CFO of Starbucks (Nasdaq: SBUX  ) said higher milk prices would continue to pressure the company's margins.
  • Also in April, Procter & Gamble (NYSE: PG  ) and PepsiCo (NYSE: PEP  ) joined Coca-Cola (NYSE: KO  ) , in announcing that, in the face of rising commodities prices, it would shrink some package sizes, rather than raise prices, in an effort to protect gross margins.
  • In March, sportswear giant Nike (NYSE: NKE  ) said it would raise its prices to offset cost increases, since commodity price increases had hurt the previous quarter's margins.

With plentiful evidence that rising commodity prices are having a knock-on impact on broader price inflation, that raises several questions:

Why does the Fed look at core CPI instead of headline CPI?
According the Janet Yellen, the Vice-Chair of the Fed's Board of Governors, the Fed focuses on core CPI simply because it has proved to be a better predictor of future headline inflation than headline inflation itself.

Is core CPI really a better predictor of future inflation?
Daniel L. Thornton -- a vice-president and economic advisor to the Federal Reserve Bank of St. Louis -- found that the existing research on this question is inadequate, and doesn't establish the superiority of core CPI.

Should the Fed use headline CPI instead?
Dissatisfied with the research he reviewed, Thornton ran tests to determine whether core or headline CPI has proved a better predictor of inflation over a series of two- and three-year periods. (That timeframe corresponds to the "medium term," which ought to be the basis for Fed policy.)

Thornton found differences in the performance of the two indicators over different time periods. For example, prior to the mid-1980s, the core CPI did a little bit better. However, none of those differences was statistically significant.

In other words, Thornton's analysis suggests that there is no reason to prefer one over the other to get a sense of future inflation. If the data doesn't support one choice over the other, how did the Fed choose to focus on core CPI?

Let it out, Ben
Thornton believes that the tests he carried out are relatively simple -- only in economics would this be considered a shortcoming -- and that the Fed may use different tests to assess the usefulness of core vs. headline CPI.

If that's the case -- and it looks like the overwhelmingly likely explanation to me -- Thornton is absolutely correct that the Fed would be wise to release that research and data for public scrutiny. Doing so would promote more research on the topic, which could lead to improved decision-making on interest rate and monetary policy. In addition, it would be consistent with the Fed Chairman's recent efforts to promote greater transparency in the workings of the central bank.

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Read/Post Comments (10) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 24, 2011, at 4:47 PM, David369 wrote:

    They know what they are doing and base their actions on sound science, right? Uh, well, maybe they don't know what they are doing nor do they base their actions on anything sound or even approaching common sense. So far I haven't been real impressed with much of anything they've done. Bank bail out? No, that didn't work out so well except for the banks who were supposed to give more loans but instead bought other banks. Our tax dollars at work and we didn't even get a toaster... I don't think they want public input or suggestions on how to improve their decision making process. They probably don't see any problem and certainly don't want any problems pointed out to them.

  • Report this Comment On May 24, 2011, at 4:50 PM, Acesnyper wrote:

    Ben's out of touch with reality.

    Frankly he scares me.

  • Report this Comment On May 24, 2011, at 6:04 PM, mountain8 wrote:

    Washington is out of touch. Ben's just a government lackey doing what he is paid for (by banks, oil companies etc.)

    I like to think I'm a typical retired SS recipient:

    I am not going to buy another house/home.

    I am not going to buy a car.

    I don't travel much.

    I don't even vacation much.

    Kids are done with college.

    I have no large, long-term purchases in my future,

    EXCEPT GAS/ENERGY AND FOOD. I really don't give a d*((%%$ about the cost of a new home. I just want to keep my car running and my family fed. And no increase in income for 4 years. Rah for the Government.

  • Report this Comment On May 24, 2011, at 9:26 PM, ETFsRule wrote:

    Neither core CPI nor headline CPI predicts future inflation. They both just tell you about current inflation.

    The reason core CPI is better, is simply because it's less volatile.

    People often take issue with this explanation, but that's only because they haven't actually researched the issue & they don't know what they're talking about.

    Over the long run they are both the same, but core CPI is more accurate in the short-term because it has fewer fluctuations.

    http://research.stlouisfed.org/fred2/graph/?g=AP

    Raising rates now would be stupid.

  • Report this Comment On May 24, 2011, at 9:38 PM, TheDumbMoney wrote:

    ETFsRule, well-spoken.

    Also, the Atlanta Fed 'macroblog' did some nice articles on core CPI earlier this year, which people might want to check out in that site's archives.

    And speaking of volatility, gas prices at my local station are down about 7% just in the last week or two. So, um, help! -- clearly deflation is upon us!!!!!

  • Report this Comment On May 24, 2011, at 11:47 PM, TuttleEsq wrote:

    It is hard to be too critical of Chairman Bernanke as the cause of our economic problems stems primarily from the policies of the Executive Branch and the failings of the Legislative Branch over an extended period of time. Core CPI has been adopted and used because it minimizes the amount of benefit increases to Social Security recipients as well as other such benefit programs. The use of Core CPI also tends to hold down the "poverty level" amounts calculated to allow citizens to claim various benefits and qualify for eligibility standards for various social programs. While it is absolutely necessary to make changes and adjustments to Social Security, Medicare, Medicaid programs, it is still necessary for the government to honestly and fairly administer all such benefit programs. All contributions are now funneled directly into the U.S. Treasury instead of into the trust funds. I am certain that the majority of the recipients have no understanding of the difference between the CPI Index and the Core CPI and how it is being used to fool them. It is all too typical of intentionally deceptive policies of government. Note, it is a violation of law for a corporation to not rectify an unfunded liability in its retirement fund. However, the U.S. government manages trust funds for Social Security, Medicare and Medicaid, etc., but there are no earning assets held by any of those government managed trust funds. In reality, those funds are entirely empty and yet the long-term unfunded liability is estimated to be in the range of $60 to $80 trillion dollars at the U.S. dollars' current value. If there is accelerating price inflation in future years, as I believe will happen, then the total unfunded liability of these trust funds will be higher by some multiple of the current estimates. One does not need to be a mathematition to understand that the actual payouts owed in future years cannot possibly be paid by the government. The current high level of unemployment has driven the final nail in the coffin of these goverment administered trust funds as the inflow of funds no longer even satisfies the current outflow of funds being paid. However, given that the trust funds are really empty now, I guess that it no longer matters that excess receipts have evaporated. The sole effect is that the annual government budget deficit is no longer being minimized by Social Security, Medicare and Medicaid contributions. I am hopeful that voters will seriously ponder these matters prior to the national election in 2012 as our country has no future if we continue on the current path that we are on now.

  • Report this Comment On May 25, 2011, at 12:33 AM, whereaminow wrote:
  • Report this Comment On May 25, 2011, at 9:57 AM, gazza05 wrote:

    @mountain8

    "Ben's just a government lackey doing what he is paid for (by banks, oil companies etc.)"

    So is he a government lackey?

    Or is he employed by banks, oil companies, etc?

    Conflating the Fed with the Government and Big Business just isn't realistic.

  • Report this Comment On May 25, 2011, at 12:14 PM, Dmama wrote:

    David in Qatar

    GREAT link above. Helped clarify the difference between the two CPI measurements!

    And he's right ... for the wealthy, food and energy costs are a smaller percentage of overall household expenses. But for us simpler folk, we feel the squeeze big time when it costs more to keep the lights on, and tank up for work!

    Not to mention my kids decide to keep growing each year ... which means more groceries at these prices, not less! :)

    Dmama

  • Report this Comment On May 25, 2011, at 5:49 PM, rfaramir wrote:

    best takeaway from David's link: "As far as I am concerned, the Fed has no correct economic theory which justifies increasing the money supply be even one penny. And when it does increase the money supply, it simply distorts the economy in favor of those who receive the money first."

    The Fed uses the Core CPI because that lets them inflate more, hurting the little guy more, who has less pull at the Fed. Using Headline CPI would make them inflate a bit less, depriving their banker friends (and other Wall Street and political elites) from getting as much free money. They're the ones who get the new money first, so they get to buy stuff at current prices. The rest of us get the new money last and have to pay the inflated prices. Those on fixed incomes, the most vulnerable among us, practically never get the new money (see "fixed incomes") so get hurt the most.

    Long term the two are not much different, but these are the main reasons for them to prefer the Core CPI.

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