In Praise of Headline Inflation

Count core inflation as another vestige of the Greenspan era that's slowly falling out of fashion. Throughout the 1990's, Greenspan referred to core readings -- those excluding food and energy prices -- as more relevant to understanding the true rate of inflation.

The rationale was that those two components tended to be more volatile than other goods and services tracked by the government, and hence distorted the underlying inflation rate. But a new paper from economists at the Philadelphia Fed casts doubt on this view.

The researchers looked at how well different measures of inflation were able to forecast future price changes. Since August 1987 -- Greenspan's first month as Fed Chairman -- core CPI wasn't significantly better than overall CPI in predicting inflation one year out. The Fed's preferred inflation measure, core-PCE, also turned out to fare worse than headline PCE in predicting future inflation -- though the difference wasn't statistically significant the researchers say. (Alternative inflation measures released by the Cleveland and Dallas Federal Reserve Banks didn't fare any better.)

And it turns out that, besides energy, there are many other components in both the CPI and PCE which are more volatile than food prices -- save perhaps in recent months. Between 1987 and 2006, the housing, medical care, other, and services components of the CPI were jumpier than food prices. For the PCE, housing, transportation, medical care, and services were more volatile. This means that the case for ignoring food prices in order to see a true rate of inflation doesn't appear to be all that strong.

The Bernanke Fed seems to be catching on to all of this. Back in November when the Fed announced that it would reveal more information about its forecasting process, the Fed chief also revealed that the FOMC would release forecasts on overall inflation for the first time since 2004.