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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