Philly Fed: Don’t Rely On Core Inflation

"We find that food and energy prices are not the most
volatile components of inflation
and that depending on which inflation
measure is used, core inflation is not necessarily the best predictor
of total inflation…"
  (emphasis added)

-Core Measures of Inflation as Predictors of Total Inflation

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You may have overlooked a recent research piece out of the Federal Reserve Bank of Philadelphia and the Wharton School at University of Pennsylvania. Don’t.

The research team essentially found that Core Inflation is an erroneous way to measure ongoing price increases.

Both of the main rationales offered for policymakers€™ for their focus on core measures of
inflation do not survive close scrutiny, argues a group of researchers.

Their main findings were that:

-Other components of Inflation are more Volatile than Food & Energy;
-Core Inflation is less Valuable as Inflation Forecastor;
-Combining CPI and PCE inflation measures can lead to more accurate forecasts

Its worth noting that the shift in focus from total inflation to core inflation was a Greenspan era "innovation."

A quick excerpt:

"We find that core inflation, which omits food and energy prices, is
less volatile than total inflation, but the reduced volatility comes
from omitting the energy components. Several components of the CPI
exhibit higher volatility than food prices. And an index that omits
food and energy prices demonstrates slightly more volatility than a
measure that omits only the energy components and retains the food
components…

Perhaps most important, we find that including PCE inflation when
forecasting CPI inflation and including CPI inflation when forecasting
PCE inflation significantly improves the accuracy of the forecasting
model for horizons up to one year. This suggests that each measure of
inflation provides independent information that can be exploited to
yield statistically significantly more accurate forecasts."

Now you have some reading for the holiday weekend . . .

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Source:
Core Measures of Inflation as Predictors of Total Inflation
Authors: 
     Theodore M. Crone, Swarthmore College
     N. Neil K. Khettry, Murray, Devine & Company
     Loretta J. Mester, Federal Reserve Bank of Philadelphia and the Wharton School, University of Pennsylvania
     Jason A. Novak, Federal Reserve Bank of Philadelphia
Federal Reserve Bank of Philadelphia, May 2008
http://www.philadelphiafed.org/files/wps/2008/wp08-9.pdf

Download wp08-9.pdf

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