The Fed should de-emphasize core inflation

Wednesday, May 25, 2011

Core versus headline inflation has been a long-standing issue for the Federal Reserve's monetary policymaking body, the Federal Open Market Committee. In recent months, the topic has gained more attention outside the Fed with consumers facing rising energy prices.

Measures of headline, or overall, inflation include changes in the prices paid for all goods, whereas measures of core inflation include changes in all prices except those relating to food or energy. Prices for these two components have historically been more volatile than other prices. Thus, core inflation tends to be less volatile than headline inflation.

The Fed cares about the prices that households and businesses actually have to pay for their daily purchases. For that reason, controlling headline inflation -- not core inflation -- is the ultimate goal of monetary policy on the price side of the dual mandate. Despite this goal, many discussions of monetary policy within the central banking community focus on core rather than headline inflation.

The emphasis on core inflation may give the impression that the FOMC does not take into account some important price changes when making decisions about monetary policy. This is damaging Fed credibility in Main Street America.

One of the commonly stated reasons for focusing on core inflation is that it is a good indicator for headline inflation. Many analyses using U.S. data, however, do not show this claim to be true. For example, during the previous decade when energy prices were rising and the economy was expanding, core inflation was consistently lower than headline inflation -- meaning that core inflation was a poor indicator of headline inflation for several years. I find many other arguments in favor of a focus on core inflation to be misguided or outdated as well.

Consequently, I think that U.S. monetary policy should drop the emphasis on core inflation and should instead focus on headline measures of inflation. One immediate benefit of doing so would be to reconnect the Fed with American consumers, who know price changes at the gas station and the grocery store when they see them.

To solidify its position that overall inflation is a goal of monetary policy, the Fed should adopt an explicit, numerical inflation target in terms of headline inflation as many other central banks -- such as the European Central Bank and the Bank of England -- have done. By adopting an explicit headline target, the Fed would keep faith with U.S. citizens that it will work to keep overall inflation low and stable. Under these circumstances, it would then be clear that any discussion of core inflation would be in the context of trying to hit the headline inflation target.

James Bullard is the president and CEO of the Federal Reserve Bank of St. Louis.

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