Friday, October 05, 2007

Core Inflation and Price Stability

I’ll begin with a hypothetical question: If half the prices went down by 10%, and the other half went up by 10%, would that be price stability? If you have faith in the General Price Level, you may answer yes, but since the General Price Level has never revealed itself to me, nor did my parents teach me to believe in it, I must ask, “How can it be price stability if none of the prices are stable?” As a price level agnostic, I have to think that “reasonable price stability” (a phrase from the Fed’s mandate in the 1978 Humphrey-Hawkins Act) requires that at least some prices (perhaps as many prices as possible) be stable.

Now, food and energy prices are nearly impossible to stabilize, because they are so volatile, and because it’s extremely difficult, except over very long time horizons, to distinguish temporary fluctuations from longer-term trends. (One could, I suppose, choose a particular food or energy price and stabilize it by intervening directly in the market, but I think most people can agree that would not be a reasonable policy.) Given that food and energy prices cannot reasonably be stabilized, does it make sense to make a half-hearted attempt to stabilize them at the expense of destabilizing most other prices?

Many prices, on the other hand, can be reasonably stabilized, primarily because the people who actually set those prices prefer them to be stable and will be willing partners (up to a point) in any attempt to stabilize them. I would argue that pursuing “reasonable price stability” does not mean sacrificing Isaac or Iphigenia on the altar of the General Price Level. Rather, it means using monetary policy to discourage the aforementioned naturally stable prices from exiting the realm of stability.

You can see (I hope) why I think that the core inflation rate is more relevant to the Fed’s mandate than the overall inflation rate. You may say that I am just playing semantic games here, but I believe the semantics have substantive importance. For one thing, my reference to human sacrifice is not entirely metaphorical: the human cost of attempts to stabilize the general price level can be quite high when volatile commodities face upward price pressures.

More to the point, perhaps, the semantic problems with attempting to stabilize the general price level are indicative of the danger that such attempts will backfire even with respect to their semantically questionable objective. Food and energy commodities are typically traded in speculative markets, and speculative markets have been known to exhibit both excessively persistent trends and very dramatic reversals. I don’t think I need to remind anyone of what NASDAQ stocks did between 1995 and 2003. Suppose the same thing were to happen to oil. (It very well may be happening, though I don’t mean to suggest that I expect a reversal.) Suppose oil prices were to rise persistently for 5 years and then reverse dramatically. A central bank bent on achieving “general price level stability” would be forced to keep the economy weak for those first 5 years so as to drive down other prices and compensate for the rising price of oil. When oil prices began to fall rapidly, the economy would be weak, and the non-energy part of the economy would already be experiencing falling prices. Before the central bank’s reaction to the reversal had a chance to affect most prices, the “general price level” would be dropping dramatically. (The same logic also applies in reverse, if you imagine oil prices falling for 5 years and then suddenly jackknifing upward and consider what the general inflation rate would look like.)

It’s interesting to consider alternative core measures, such as the Cleveland Fed’s median CPI or the Dallas Fed’s trimmed mean measures, in the light of my agnostic semantics of price stability. A literal application of those semantics would suggest that means and medians are the wrong kinds of statistics to use. Rather, it is the mode of the price distribution that should be of concern if the objective is to stabilize as many prices as possible. My last example, though, suggests that the purely statistical month-by-month trimming of a price index is not an adequate approach. The prices that need to be stabilized are not the ones that have recently been most stable but the ones that are most likely to be stable in general. While there may still be a good case for ignoring outliers in the price distribution, there is an even better case for ignoring prices that are generally unreliable.

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21 Comments:

Blogger spencer said...

But you have to remember there is a feedback loop in this analysis. If over 5 year oil prices rise and the fed tightens into it when oil prices peak one of the reasons will be the Fed tightening.

Fri Oct 05, 06:22:00 PM EDT  
Blogger Gabriel M. said...

OK, I know it's a stupid question but I'll ask it anyway. Why not the GDP deflator? *All* prices.

Relative price movements are a good thing (tm) so the problem is, I think, the purchasing power of money, i.e. its power to purchase *anything*.

Sat Oct 06, 03:45:00 AM EDT  
Anonymous Blissex said...

“reasonable price stability”

But that does not say that the prices to stabilize are those of consumer goods; and the prices that affect most people are those of assets like houses and those of factors like capital and labour.

The enormous rise of house prices in the paste decade has been cause of a lot of instability in the ''general price level'', requiring vast changes in planning and expectations by economic agents...

Anyhow the way you frame the discussion playing semantics on a precatory bit of lawyerese seems to me entirely wrong.

If the fed's goal is to be some kind of price stability one must have regard to the wider context.

In the wider context price stability is a very bad idea, because flexible prices are the very essence of a dynamic, productive economy that adapts to different circumstances.

However there is probably a price to pay if price adjustments are too frequent or amplified by feedback loops, so the goal of the Fed should be interpreted as the viceversa: not to provide stability, but to discourage instability.

That is to engineer some degree of hysteresis via its control of money, which is the link between past and future.

And the prices whose rate of change the Fed should be dampening should be *all* prices, not just consumer prices.

The reason is that dampening is of benefit because it smooths the process of forward looking investment, savings and consumption decisions, the main feedback loops between past and future, which presumably raises efficiency.

Now it is not just consumer prices that influence those decisions; fast changes that make planning harder are more often those in prices of assets and factors.

So the last thing that the Fed should aim to stabilize is the Core CPI, because:

* The goal is not stabilization of the level of prices, but of changes.
* The prices whose change affect most economic decisions are not those of consumer goods.

Even worse, fast changes in the prices of *foreign* assets and goods can be highly relevant to the planning of domestic actors, and this means that the rate of change in the price of foreign currencies should also matter.

Sat Oct 06, 08:22:00 AM EDT  
Blogger Gabriel M. said...

I'm really skeptical that the Fed could smooth out day-to-day volatility? "Long and variable lags" and all.

What we know it can do, and arguably that's all it can do regarding prices (financial market regulation aside, that is) is to fix the inflation term in the Fisherian interest rate equation at 2+ years frequencies.

Sat Oct 06, 08:43:00 AM EDT  
Blogger Robert D Feinman said...

I'm adopting a new mantra, you get to see it first: "Question assumptions".

Why do we want price stability? What is the harm of inflation? I'll answer my own question.
1. Inflation does no harm to working people if their wages rise appropriately. This is what happened in Germany in 1923 and to a certain extent in the US in the 1970's. It works when labor can make wages rise.

2. Inflation does no harm to working people with few assets. Their furniture and clothing is outside the price system since they own it already.

3. Inflation does no harm to debtors (like mortgage holders). In fact it makes it easier for them to pay off the loans.

4. Inflation does harm lenders. This includes those who write mortgages, but also those in the rentier class that draw their income from fixed rate instruments or long-term contracts such as property leases. The face value of their holdings declines as the buying power of their (fixed) income is devalued.

So the Fed was set up to benefit the wealthy. Greenspan did a very good job of supporting the interests of this class. Throwing people out of work was, to him, a small price to pay in order to keep the wealthy protected.

Fudging with the actual inflation numbers also hurts the poor as many benefits are now inflation adjusted. The game is fixed before the details of the rules are even laid out.

Sat Oct 06, 11:57:00 AM EDT  
Anonymous Blissex said...

«I'm really skeptical that the Fed could smooth out day-to-day volatility?»

Exactly, that's why my argument is that its goal should be to limit their rate of change. Consider for example the housing bubble: the argument by Easy Al is that he did not know whether the increase was caused by fundamentals or by speculation.

But the argument presumes that the Fed should control the *level* of house prices. But if the goal is to limit the rate of change of prices, to make economic planning easier, then if the higher house prices were driven by fundamental they would reach the right new level, only more slowly than without intervention, and if they were driven by speculation, the damage would be limited by slower rise and slower fall, and perhaps the slower pace of change would reduce the extremes, not just the speed with which they would be reached.

«What we know it can do, and arguably that's all it can do regarding prices (financial market regulation aside, that is) is to fix the inflation term in the Fisherian interest rate equation at 2+ years frequencies.»

That's not an equation, it is a definition. Also the fed has two powerful levels: it still has some control over interest rates and liquidity. These drive investment decisions and the prices of assets and factors. And these are among the most powerful drivers of economic planning decisions...

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