Barry Ritholtz is unimpressed by Chairman Bernanke's latest speech:
Peter E. Kretzmer, senior economist for Bank of America, explains (more or less) what the Fed means by relating "inflation expectations" to the ability of the Fed to impact price rises (i.e., stability):
“This Fed much more so than prior Feds puts a very heavy emphasis on the role of inflationary expectations,” he said. “They believe, and research shows, that inflation expectations and the Fed’s inflation-fighting credibility has a large impact on private sector wage- and price-setting behavior.”
In other words, the Fed's emphasis on Core inflation -- jawboning, PR, propaganda, whatever -- is every bit as important to future prices as the actual underlying causes (excessive monetary creation, demand exceeding commodity supplies) of inflation.
I am not sure I buy that. Surely, psychology is important, and the collective expectations of either higher or lower prices can impact subsequent price behavior.
But this approach puts the Fed into the role of a low price cheerleader, and runs the dangerous risk of well, artificially emphasizing the irrelevant core rate of inflation rather than dealing with reality of the actual price increases as experienced by consumers.
That representation is not really wrong, but (as I have said here before) it rather stubbornly misses the point of the FOMC's intent in focusing attention on core inflation measures. The Chairman, in an earlier speech:
A commonly used analogy takes the U.S. economy to be an automobile, the FOMC to be the driver, and monetary policy actions to be taps on the accelerator or brake. According to this analogy, when the economy is running too slowly (say, unemployment is high and growth is below its potential rate), the FOMC increases pressure on the accelerator by lowering its target for the federal funds rate, thereby stimulating aggregate spending and economic activity. When the economy is running too quickly (say, inflation appears likely to rise), the FOMC switches to the brake by raising its funds rate target, thereby depressing spending and cooling the economy. What could be simpler than that?...
[One] problem with the automobile analogy arises from the central role of private-sector expectations in determining the impact of monetary policy actions. If the automobile analogy were valid, then the current setting of the federal funds rate would summarize the degree of monetary stimulus being applied to the economy, just as the pressure a driver exerts on the accelerator at any particular moment determines whether the automobile speeds up or slows down. However, in fact, the current level of the federal funds rate is at best a partial indicator of the degree of monetary ease or restraint.
Barry seems to prefer what Ben described as a "simple feedback rule"...
... Under a simple feedback policy, the central bank's policy instrument--the federal funds rate in the United States--is closely linked to the behavior of a relatively small number of macroeconomic variables, variables that either are directly observable (such as employment or inflation) or can be estimated from current information (such as the economy's full-employment level of output)...
A classic example of a simple feedback policy is the famous Taylor rule... In its most basic version the Taylor rule is an equation that relates the current setting of the federal funds rate to two variables: the level of the output gap (the deviation of output from its full-employment level) and the difference between the inflation rate and the policy committee's preferred inflation rate. Like most feedback policies, the Taylor rule instructs policymakers to "lean against the wind"; for example, when output is above its potential or inflation is above the target, the Taylor rule implies that the federal funds rate should be set above its average level, which (all else being equal) should slow the economy and bring output or inflation back toward the desired range...
... but the Chairman emphasized that there is another way:
The second general approach to making monetary policy is what I am today calling a forecast-based policy... As the name suggests, under a forecast-based policy regime, policymakers must predict how the economy is likely to respond in the medium term--say, over the next six to eight quarters--to alternative plans for monetary policy....
Taking both their baseline forecast and the various risks to that forecast into account, policymakers then choose the plan that seems most likely to produce the best results overall. Their current choice of interest rate corresponds to the first step in implementing the preferred plan. This process is to be repeated at each meeting, with the policy plan being modified as necessary in response to new information or new knowledge about the economy.
The role of inflation forecasting was a prominent feature of BB's speech yesterday, and it is precisely in a forecast-based policy framework that the rationale for core inflation takes root. From today's Real Time Economics blog:
The Federal Reserve’s focus on core inflation has renewed attention to alternative measures that aim to separate the underlying inflation trend from month-to-month volatility, and some such measures are suggesting higher prices ahead.
Both the Cleveland Fed and the Dallas Fed produce “trimmed mean” price indexes that generally exclude the most volatile categories in a given month. The presidents of both banks have expressed concern that core inflation may not adequately capture current inflation risks.
Michael Bryan, an economist at the Cleveland Fed, says the bank’s trimmed mean consumer price index does a better job in the short term at predicting future overall inflation than core inflation does. “It’s really reducing the noise and improving the signal,” Bryan said. “There’s almost no signal in the overall month-to-month CPI.”
In his comments yesterday the Chairman made it perfectly clear that the general idea is to get a bead on the inflation trend:
The forecasting procedures used depend importantly on the forecast horizon. For near-term inflation forecasting--say, for the current quarter and the next--the staff relies most heavily on a disaggregated, bottom-up approach that focuses on estimating and forecasting price behavior for the various categories of goods and services that make up the aggregate price index in question. For example, we know from historical experience that the prices of some types of goods and services tend to be quite volatile, including not only (as is well known) the prices of energy and some types of food but also some "core" prices such as airfares, apparel prices, and hotel rates... Conceptually, one might think of this effort to distinguish transitory from persistent price changes as a more nuanced way of estimating the underlying inflation trend, analogous to the trend measures provided by more mechanical indicators such as trimmed-mean or weighted-median inflation rates.
An accurate forecast of very near-term inflation is important not only for its own sake but also because it provides a better "jumping-off point" for the longer-term forecast. Because inflation continues to exhibit some inertia, improved near-term forecasts translate into more-accurate longer-term projections as well.
Barry is not swayed...
... all of the prior chatter about removing volatile food energy prices due to their erratic price behavior was quite simply [bovine excrement]. Based on yesterday's Bernanke speech, we learn that the emphasis on the Core rate of inflation is about influencing psychology and sentiment -- not smoothing out volatile data.
... but I think that Mr. Bernanke's words speak for themselves.