- The Washington Times - Tuesday, June 28, 2005

Federal Reserve Chairman Alan Greenspan’s favorite inflation indicator is looking a little dusty these days.

The chairman’s preferred measure of underlying inflation is the Commerce Department’s core chain-type personal consumption expenditure price index. The core measure excludes food and energy prices from the overall index since they are relatively volatile and their temporary swings can obfuscate the underlying inflation trend. Chain weighting allows the index to take account of changes in expenditure patterns due to shifts in relative prices.

Jim Dolmas, a Federal Reserve Bank of Dallas senior economist and policy adviser, recently completed a revealing inflation study. The results are reported in the Bank’s May-June 2005 issue of Southwest Economy. The study, “A fitter, trimmer core inflation measure,” refines the personal consumption expenditure [PCE] core price index and produces “a new measure of core PCE inflation… and a somewhat different characterization of the economy’s recent inflation experience.”

Mr. Dolmas examined the detailed components of the PCE price index since the late 1970s and found some items in the food and energy categories have indeed been volatile, but some have not (e.g., food consumed away from home).

Thus, the traditional core PCE index, which indiscriminately excludes all food and energy prices, was too crude. Because it tosses out valid signals along with noise, useful information is lost. The traditional measure also includes volatile components outside food and energy categories that sometimes blur the underlying inflation trend and need to be removed.

Building on earlier work of economists Michael Bryan and Stephen Cecchetti, Mr. Dolmas trimmed from the PCE index those individual price changes that varied most, retaining components that yielded a recalculated inflation rate closest to the smoothed underlying trend in historical core inflation. The inflation signals of this trimmed PCE index proved more durable and less transitory than the traditional PCE core index.

The accuracy gained by using an optimally trimmed mean of monthly PCE core prices, when compared to the traditional core measure, averaged about 0.75 percentage point annually. Mr. Dolmas compared the two inflation measures not only month-to-month, but also for three-, six-, and 12-month periods. The trimmed core price estimates were consistently shown the more accurate inflation gauges.

For the period since 1996, the trimmed core inflation rate estimates are generally higher than the cruder traditional measure. While both the trimmed and traditional measures signaled declining inflation in 2003, the drop in the trimmed rate was not as great as in the traditional measure.

Both rates rose in the first half of 2004, though the trimmed rate was higher and more sustained. Both measures showed inflation subsequently eased then rose again, with the trimmed rate mostly above the traditional core rate.

The trimmed mean PCE price data are a significant addition to existing measures of inflation. The Dallas Fed would perform a valuable service if it regularly reported the new estimates on its Web site, including any necessary updating and revisions.

A model to follow is the Cleveland Fed, which reports every month its adjusted measure of core Consumer Price Index (CPI) inflation, a median estimate that also avoids crudely throwing out all food and energy price information.

So far this year, that inflation rate is up 2.3 percent on average over last year, well above the 1.7 percent average increase in the conventional core PCE price index. The traditional core inflation rates for both the chained and unchained CPI indexes have also been running higher than the rate for the conventional core PCE index.

For the most part, the core price indexes refined by research lately have been showing higher year-over-year inflation rates than the traditional government-reported measures, a pattern that cannot have escaped Fed policymakers’ attention.

The Fed research findings also suggest Mr. Greenspan should perhaps trade in his favorite PCE core inflation measure for a more streamlined Fed-improved measure.

Cynics outside the Fed have criticized Mr. Greenspan’s preference for the core PCE price index over alternative measures, such as the core CPI, saying it’s easier to reduce inflation by picking a lower inflation measure.

Such statements are nonsense. The Fed has been at the forefront of inflation research, has produced invaluable studies that have helped guide monetary policy, and lets its many voices contend.

Alfred Tella is former Georgetown University research professor of economics.

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