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Is the Six Percent Rise in Producer Prices a Signal that Inflation is Coming?

Many news reports are noting the six percent increase in the producer price index on a year over year basis and wondering if it signals that inflation is back. However, this report should not be read as a warning that inflation is just around the corner.

Why? The pass through from producer prices to consumer prices is less than 100 percent in any case, and in some cases it is close to zero. Pass through to consumer prices is smaller when the change in producer prices is temporary, and core inflation measures indicate that most of the rise in producer prices was due to a rise in food and energy prices. Once the temporary changes in food and energy prices are stripped out, the core inflation rate only increased .9 percent over the previous year, and that isn't much different from previous measures.

But which measure of inflation should we pay attention to if we want to predict future inflation? Why do we use core inflation instead of "headline" inflation for this purpose? This is from a post I wrote on this in late August 2008 (slightly edited):

There is a lot of confusion over the Fed's use of core inflation as part of its policy making process. One reason for confusion is that "core inflation" is used for several different purposes.

First, core inflation is used to forecast future inflation. For example, this recent paper uses a "bivariate integrated moving average ... model ... that fits the data on inflation very well," and finds that the long-run trend rate of inflation "is best gauged by focusing solely on prices excluding food and energy prices." That is, this paper finds that predictions of future inflation based upon core measures are more accurate than predictions based upon total inflation.

Second, we also use the core inflation rate to measure the current underlying trend in the inflation rate. Because the inflation rate we observe contains both permanent and transitory components, the precise long-run inflation rate that consumers face going forward is not observed directly, it must be estimated. When food and energy are removed to obtain a core measure, the idea is to strip away the short-run movements thereby giving a better picture of the core or long-run inflation rate faced by households. (I should note, however that this is not the only or even the best way to extract the trend, and the Fed also looks at other measures of the trend inflation rate that have better statistical properties, e.g. "trimmed mean" measures. Also, the first use of core inflation described above is for forecasting future inflation rates, the second attempts to find today's trend inflation rate. There is a way to combine the first and second uses into a single conceptual framework, but it seemed more intuitive to keep them separate.)

Let me emphasize one thing. If the question is "what is today's inflation rate," the total inflation rate is the best measure. It's intended to measure the cost of living and there's no reason at all to strip anything out. It's only when we ask different questions such as what the inflation rate will be in the future -- essential knowledge for policymakers due to lags between the implementation of policy and its effects -- that different measures are used.

Third, and this is the function that is ignored most often in discussions of core inflation, but to me it is the most important of the three, it is the inflation target that best stabilizes the economy (i.e. best reduces the variation in output and employment).

In theoretical models used to study monetary policy, the procedure for setting the policy rule is to find the monetary policy rule that maximizes household welfare (by minimizing variation in variables such as output, consumption, and employment). The rule will vary by model, but it usually involves a measure of output and a measure of prices, i.e. generally a Taylor rule type framework comes out of this process (a rule that links the federal funds rate to measures of output and prices).

However, in the Taylor rule, the best measure of prices to target is usually something that looks like a core measure of inflation. Essentially, when prices are sticky, which is the most common assumption in modern theoretical models, it's best to target an index that gives most of the weight to the stickiest prices (here's an explanation as to why from a post that echoes the themes here). That is, volatile prices such as food and energy are essentially tossed out of the index.

The core inflation rate you see in the news, the CPI less food and energy, does do a fairly good job of representing the information the Fed uses to forecast future inflation, i.e. it is a measure of the trend rate of inflation (but not the best one), and it also does well at approximating the information the Fed will use to set policy.

[See also Everyday Low Prices at The Economist for more on the (lack of) relationship between headline producer prices and consumer prices.]

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