In the latest issue of its publication “The Rocky Mountain Economist”, Kansas City Federal Reserve Bank (i.e., the KC FED) Dr. Alison Felix – regional economist and lead officer in the states of Colorado, Wyoming and New Mexico, describes “describes common measures of inflation and explores how recent inflation trends compare to the policy objectives of the Federal Reserve.”
This article can be found at the following web address: http://kansascityfed.org/publicat/rme/rme-2Q-2013.pdf?ealert=rme0610.
Dr. Felix describes how “Since January 2012, the Federal Open Market Committee (FOMC) has maintained a long-run target for the inflation rate of 2 percent. This means that the FOMC is pursuing monetary policy aimed at meeting 2 percent annual inflation.”
Therefore, it is important to understand just what specific measure of inflation that the U.S. FOMC is paying attention to in terms of this “2% annual inflation target”.
Felix goes on to state: “The personal consumption expenditure (PCE) price index is one broad-based and frequently cited measure. It is the measure of inflation used as a monetary policy target by the Federal Reserve and is forecasted throughout the year by the FOMC. The PCE price index measures the prices of goods and services purchased by households or by nonprofits on behalf of households; estimates of the PCE price index are released by the Bureau of Economic Analysis each month. In March, the PCE price index estimated that consumer prices had increased 1 percent in the past year.”
One part of this article explains the difference between “Headline Inflation” and “Core Inflation”:
“Because food and energy prices tend to be the most volatile components of inflation, core inflation, a measure
of inflation that excludes these purchases, is often used to examine underlying inflation trends. Core PCE inflation excludes energy purchases, such as gasoline and electricity and food purchases for home consumption. Core PCE inflation has increased 1.1 percent in the past year as of March, similar to overall headline inflation of 1 percent. Headline inflation, however, has a much larger variance because of large swings in food and energy prices (Chart 2).”
In this article Dr. Felix goes on to explain how the PCE price index relates to the commonly quoted Consumer Price Index (CPI).
Alison Felix, Kansas City Federal Reserve Bank Assistant Vice President and Denver Branch Executive
In April 2011 James Bullard, the head of the St. Louis Federal Reserve Bank, commented on issues pertaining to “Headline versus Core Inflation” in the following article: http://www.stlouisfed.org/publications/re/articles/?id=2089
“Monetary policymakers are responsible for maintaining overall price stability, which is usually interpreted as low and stable inflation. In order to decide on appropriate
policy actions given their objective, policymakers need to know the current rate of inflation and where it is headed. What makes for a reliable predictor of future inflation has been debated throughout the years and continues to be the subject of economic analyses today. One debate that has received attention recently is whether the focus should be on headline or core inflation. The former is calculated from an all-item index, whereas the latter is commonly calculated from a price index that excludes the highly volatile food and energy components.
A natural question to ask, then, is: If the Fed ultimately cares about overall prices, why would it ever look at core inflation, thereby excluding items on which Americans spend a nontrivial portion of their income? The reason is because, historically, the food and energy components were highly variable (for example, due to temporary supply disruptions), and their large price fluctuations were usually expected to correct themselves within a relatively short period of time. Consequently, the FOMC focuses on core PCE as a measure of underlying inflation trends and, thus, a predictor of future headline PCE inflation. Assuming core PCE is an appropriate measure to use, we would expect to see headline inflation fluctuate above and below core inflation over the short run.”
“As I asserted in my previous commentary, one interpretation is that, during times of continuous increases in the relative price of energy, perhaps core PCE is a misleading indicator of underlying inflation trends. This implies that core PCE may not be a good predictor of future headline inflation after all. Under these circumstances, headline PCE inflation should probably have more weight in policymaking decisions than core PCE inflation.”
“Of course, if the evidence shows that core PCE is not the best measure to focus on for policy purposes, exploring other options may make sense. One alternative measure could include all components but put less weight on those that have highly volatile prices. Such a measure would avoid systematically excluding certain prices and would more accurately reflect consumers’ expenditures. Additionally, studies have shown that other existing “core” measures, such as PCE trimmed-mean or PCE weighted-median inflation, may be better predictors of headline PCE inflation than core PCE. In the end, the policymakers’ goal is to use the inflation measure that helps them achieve low and stable headline inflation in the long run.”
It is important to read all of Bullard’s April 2011 article to be sure and understand the context of each of these statements quoted above.
James Bullard, St. Louis Federal Reserve Bank President and CEO
Finally, for perspective, see the following chart of consumer inflation expectations of approximately 3% from the University of Michigan (Source: http://research.stlouisfed.org/fred2/series/MICH)