- The Washington Times - Wednesday, December 28, 2005

The media constantly remind us the Federal Reserve’s favorite measure of core inflation is the personal consumption expenditure chained price index excluding food and energy, reported monthly by the Commerce Department’s Bureau of Economic Analysis (BEA). But that measure may have lost its preferred status with Fed policymakers.

Food and energy components of the personal consumption expenditure (PCE) price index are pruned from the total because they are often volatile. The Fed focuses on core prices to better observe the underlying trend in inflation.

However, excluding all component food and energy items is somewhat crude since not all the individual prices in these categories may be volatile from month to month. Also, nonfood and nonenergy items in the overall index may jump around some months and obscure the underlying inflation trend and also should be considered candidates for temporary exclusion.

To refine the traditional PCE core price measure, the Fed has invested in research that identifies and trims away the noisiest price components each month, whether in the food, energy or any other category. If a particular food or energy item is relatively well behaved in a particular month, it gets to stay in the core measure. Otherwise, it’s excluded. The same test is applied to all items.

The technique sorts all individual PCE monthly price changes, arranging them from the highest to the lowest. Then a percentage of extreme changes at the upper end of the range, and a percentage at the lower end, are thrown out.

The resulting core rate is a weighted average of the surviving price items. The fraction of items included or excluded is determined by research, based on historical data.

The resulting refined series, called a trimmed mean inflation rate, is calculated and reported monthly, on the same day the BEA inflation data are released, by the Federal Reserve Bank of Dallas (www.dallasfed.org), where much of the price research was carried out. The technical studies explaining the research can also be found on the Dallas Fed’s Web site.

Fed researchers thoroughly tested the new series against the cruder BEA core inflation rate. They concluded the “resulting inflation measure has been shown to outperform the more conventional ‘excluding food and energy’ measure as a gauge of core inflation.” A fair conclusion that has not been disputed.

By all appearances, the Fed now has a new preferred core inflation measure. The media need to catch up with recent developments and begin regularly reporting the new monthly series. A boost from Fed Chairman Alan Greenspan or Fed Chairman-designate Ben S. Bernanke would help. Mr. Bernanke has been a fervent proponent of Fed transparency, so perhaps he will tell us his druthers.

As an inflation indicator, the new Fed measure has its own story to tell. For the last half-year ending in November, monthly changes in the Fed core rate were consistently above the BEA core inflation rate, averaging a sizable 0.6 percentage point higher at an annual rate. The BEA measure averaged 1 percent annualized, remaining well within the Fed’s 1 percent to 2 percent comfort zone for core inflation.

By comparison, the Fed’s trimmed rate averaged 2.1 percent. However, the differential in rates narrowed in November, the latest month for which data are available.

The Fed’s 12-month trimmed inflation rate has shown a more disturbing trend. It not only has been consistently above the BEA year-over-year core inflation rate in recent months, it has been increasing faster.

In May, it was 0.1 percentage point higher than the BEA rate, in June through August 0.2 point higher, in September and October 0.3 point higher, and in the latest monthly report for November, at 2.2 percent, it was 0.4 point higher.

Core inflation hasn’t yet got out of control. And it probably won’t if only because the Fed’s continued tightening recognizes the inflationary pressures reflected in its new price measure.

In the first half of 2006, the economy is likely to continue expanding faster than its potential growth rate, further drawing down capital and labor resources. In its Dec. 13 policy statement, the Fed’s Open Market Committee noted “possible increases in resource utilization… have the potential to add to inflation pressures.”

The worrisome message in the new and improved inflation measure is yet another reason for the Fed to risk overshooting rather than undershooting before ending its tightening cycle.

Alfred Tella is former Georgetown University research professor of economics.

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