Tags: Fed | Inflation | Policy | money

Fed Official: Core Inflation Best Gauge for Monetary Policy

By Michelle Smith   |   Thursday, 04 Aug 2011 11:12 AM

Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, believes that the underlying rate of inflation is the best gauge to drive monetary policy.

And, according to the Dow Jones Newswires, he recently wrote in his bank's annual report that he would “be paying close attention to the behavior of core inflation."

Kocherlakota says that monetary policy will need to evolve in response to ongoing shocks and new information.

As Americans are faced with rising prices for everyday needs, there those that argue that core inflation, which excludes food and energy costs, is an indicator that ignores some of the most vital pieces of information.

One of the opponents of using core inflation to determine monetary policy is James Bullard, President and CEO of the Federal Reserve Bank of St. Louis

In his speech, Measuring Core Inflation: Core is Rotten, Bullard said “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 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.”

Bullard believes that “U.S. monetary policy needs to de-emphasize” core inflation noting that many of the established ideas used to support its use “have rotted over time.”

He said "they probably made little sense from the start,” he said in his speech.

The sensible alternative, according to Bullard, is headline inflation, which includes an assessment of food and energy prices among other household expenses.

By focusing on core inflation instead of headline inflation, the Fed sees a much different picture than the one that the average American is living in. This presents the risk that using core inflation as a guide could result in an out-of-touch monetary policy.

A Financial Times blog notes that “headline CPI inflation rose rapidly in Q1 and Q2, mostly because of the rise in commodity prices. It was this rise in inflation which squeezed household incomes and consumption...”

Perhaps even larger than the effects on individual households is the fact that the Financial Times, says that that squeeze from headline inflation is “the main proximate cause of the recent weakness of GDP growth.”

It was also noted that there is a division among those at the Fed in the debate over this year's rise of core inflation rates. One group believes that the rise is temporary and caused by pass-through effects from higher energy prices, and the firming in the residential rental market.

This suggests that energy prices are indeed an important indicator when assessing inflation and thereby monetary policy. “Yet the Fed is sticking to its guns, arguing that when it comes to interest rates, core inflation rates are the most important” says.

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