Washington
ANY American who has shopped for groceries or pumped gasoline in the last few months knows that prices for food and energy have been soaring. Demand from fast-growing Asian economies is one major contributor to price increases; the turmoil in the Middle East is another.
All of this has made some economists and lawmakers in the United States nervous. They fear that higher prices for commodities will translate into higher prices for all goods and services and that the Federal Reserve, by ignoring commodity prices, has become lax on inflation.
While the anxiety is understandable, the fears are misplaced. They result from a profound misunderstanding about whether food and energy prices today help predict overall inflation tomorrow.
There are two fundamental measures of inflation: overall (or “headline”) inflation and “core” inflation, which excludes food and energy prices because they are very volatile and mostly transitory and as a result don’t necessarily reflect underlying inflation trends. A central objective of the Fed’s monetary policy is price stability, defined as a low, steady rate of overall inflation. So are rising food and gas prices a sign that the Fed is falling down on the job?
The answer is no. There is very little that the Fed can do to control today’s inflation, whether core or headline. What the Fed does influence is inflation a year or two down the road, which is why it needs to look to the future, not overreact to the present.
The most significant question for the Fed, then, is whether overall or core inflation right now is a more reliable gauge of where headline inflation will be next year. And the data unequivocally tell us that core inflation better predicts overall inflation tomorrow.
Given that core inflation is close to 1 percent, overall inflation next year will likely also end up at about 1 percent, well below the Fed’s almost explicit objective of 2 percent.
But wait a moment, the Fed’s critics say. They like to point out that the data haven’t always told the same story about the link between underlying and overall inflation.
For instance, during the 1970s and early 1980s, an era of debilitating inflation, the markets had no confidence in the Fed’s ability to keep prices stable. This meant that any increase in prices, including those for volatile items like food and energy, were almost immediately and fully translated into expectations of higher overall inflation in the future. Those expectations, in turn, gave rise to actual increases in other prices, not just food and energy. (If workers expect that inflation will be 2 percent in the coming year, they will demand a wage increase that is 2 percentage points higher than they otherwise would to keep improving their standard of living.)
So in the ’70s, increases in food and gas prices affected both core and overall inflation. Some believe this is still the case today. But it isn’t.
Since the inflationary era ended in the early ’80s, the Fed has earned a reputation for keeping inflation in check. For more than a decade, the markets have operated under the assumption that in the long term inflation will be stable. This means that spikes in food and energy prices do not get translated into expectations of higher inflation down the road and thus do not lead to a general increase in prices, today or tomorrow. In light of the evidence, the Fed is right to pay more attention to core inflation than to overall inflation when making decisions about interest rates.
Critics who want the Fed to raise rates immediately in response to rising food and energy prices also tend to be skeptics of the Fed’s decision last year to pump $600 billion into the economy by purchasing Treasury securities — even though, in my view, the two phenomena are entirely separate.
The skeptics point out that the Fed’s purchases, which were intended to lower unemployment by making borrowing cheaper and thus encouraging businesses to hire, “monetize” the nation’s debt, meaning that the Fed is essentially printing money to finance the government. That in turn is said to increase the risk of substantially higher inflation expectations and, eventually, overall inflation.
The Fed, this argument goes, just won’t be able to act quickly enough to turn off the spigot when the time comes to do so.
But the Fed can raise interest rates directly any time it wants. In addition, it could start to sell the huge volume of Treasury securities and other financial assets on its books, which would also place upward pressure on rates.
Would the Fed act in time? I expect that it will. And even if it doesn’t act in time, and inflation expectations start to get out of line, I am confident that the Fed would tighten monetary policy quickly and aggressively enough to restore price stability and maintain its credibility on inflation. You can take that to the bank.
Laurence H. Meyer, an economic consultant, was a governor of the Federal Reserve from 1996 to 2002.
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