We've Overshot the Fed's Upper Inflation Limit

The Consumer Price Index (CPI) excluding food and energy - the core inflation index reported by the Bureau of Labor Statistics (BLS) - rose in August by 2.0 percent year-over-year, reaching the upper limit of the Federal Reserve's informal 1.5 - 2.0 percent inflation target range. The average increase in core inflation for the last six months is 2.7 percent at an annual rate, well above the Fed's upper limit.

It wasn't long ago that then-Fed chairman Alan Greenspan said his inflation goal would be zero if the price data weren't upward biased, adding it was about one percent given economists' estimates at the time of a one percentage point overstatement in the data. One might wonder: are we on a target stepladder?

In the BLS core inflation measure, food and energy are excluded from the total CPI because these components are at times volatile and can obscure the longer-term trend in prices. However, critics point out that there are months when the food and energy components are not volatile and that, furthermore, over extended periods the excluded items can reveal trends that should be taken into account. When these items are excluded from the index, valuable information is being lost.

To address these shortcomings, the Federal Reserve Bank of Cleveland several years ago developed a more sophisticated "trimmed mean" measure of core inflation that draws on all categories of the BLS consumer price data. The Bank's methodology examines monthly variability in prices across the board and excludes the "noisiest", i.e., the individual items that are the most volatile each month regardless of category.

The Cleveland Bank's trimmed mean core inflation measure in August rose to 2.4 percent, year over year, from 2.1 percent in July. Month to month, it showed a 0.3 rise in core prices for both July and August, or over 3 percent at an annual rate, exceeding the Fed's upper inflation limit.

The Cleveland Fed also calculates and reports an alternative monthly core consumer inflation measure that is a weighted median of all the component prices in the CPI. As such, it eliminates the distorting influence of extreme price changes with a minimum of information loss.

By this measure, core inflation in August was 2.0 percent year over year. However, from July to August the core rate was up 0.3 or by more than 3 percent at an annual rate, consistent with the August rise in the Bank's trimmed mean core inflation rate.

Studies have found that the improved Cleveland Fed core inflation series better forecast inflation than the cruder traditional CPI core index. And you can be sure that the members of the Fed's policymaking Federal Open Market Committee (FOMC) know this and pay close attention to the Cleveland Bank's core inflation estimates every month.

The Dallas Fed also calculates a trimmed mean core inflation rate for the Personal Consumption Expenditure (PCE) price index, using data from the Bureau of Economic Analysis. However, the BEA data are less timely than the BLS data, with the latest core inflation estimate available for July. Year-over-year PCE core inflation for July came in at a relatively tame 1.6 percent, although the June to July change at an annual rate registered a 2.4 percent increase.

James Bullard, President of the Federal Reserve Bank of St. Louis, rejects the use of a core inflation measure for monetary policy. In an article in the Bank's July-August 2011 Review, "Measuring Inflation: The Core Is Rotten," he argues that the goal of monetary policy should be to control headline inflation, not core inflation.

If Bullard's view were to prevail in FOMC meetings - a long shot - the Fed would be fighting an August CPI inflation rate of 3.8 percent year-over-year, and over 4 percent from July to August at an annual rate. Question: in such a world would the Fed's informal inflation target be pushed higher, or would the FOMC shift to a tighter mode?

Looking at the different estimates of core inflation of late, it seems clear that we have overshot the Fed's upper limit of 2 percent. FOMC members know this but, not surprisingly, don't talk it up, and the media largely ignore the Fed's improved core inflation measures.

If FOMC members believe, as Chairman Bernanke has been saying repeatedly, that the rise in prices this year is transitory and that inflation will soon settle down, then they will likely approve of the Fed's buying fewer short term and more long term treasuries when they meet this week - not that such a policy is likely to help much. But if they expect longer term inflation expectations to notch up and core inflation to rise further, additional easing probably won't happen.