Frederic S Mishkin: Headline versus core inflation in the conduct of
monetary policy
Remarks by Mr Frederic S Mishkin, Member of the Board of Governors of the US Federal
Reserve System, at the Business Cycles, International Transmission and Macroeconomic
Policies Conference, HEC Montreal, Montreal, 20 October 2007.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
In discussing and thinking about the conduct of monetary policy, many central bankers focus
on core inflation - that is, a measure of inflation that excludes the rate of increase of prices
for certain volatile components in price indexes.1 The Federal Reserve, for example, pays
particular attention to the rate of growth of the core personal consumption expenditure (PCE)
deflator, which excludes food and energy prices. Indeed, in the presentation of its twice
yearly Monetary Policy Report to the Congress, the Federal Reserve Board reports the
projections of Federal Open Market Committee participants regarding core PCE inflation, not
headline inflation, the latter of which includes all items in the price index. Here in Canada,
unlike in the United States, the central bank maintains an explicit inflation target. The Bank of
Canada states its target in terms of the headline consumer price index, and although this
choice of inflation measure contrasts with the Federal Reserve's preferred index, the
difference is not nearly as great as it appears on the surface. In fact, the Bank of Canada
monitors a number of inflation measures and uses core inflation as an "operational guide" in
coming to its monetary policy decisions and discussing these decisions with the public.
Does it make sense for a central bank to concentrate on core inflation? After all, households
almost daily pay for energy and food items - which are excluded from the most prominent
measures of core inflation - when they fill up their cars at gas stations or visit a grocery
store. Households, particularly less-affluent households, spend a major portion of their
budgets on food and energy. A focus on core inflation, which excludes these items, might be
viewed as indicating that monetary policy makers are out of touch with what consumers
really care about. Wouldn't it be better for monetary policy authorities to focus on headline
inflation so that they include food and energy in their monitoring of consumer price inflation?
As I will argue, this is not an either-or decision. It does indeed make sense for central banks
to emphasize headline inflation when determining the appropriate stance of monetary policy
over the medium run, but policymakers also are right to emphasize core inflation when
deciding how to adjust policy from meeting to meeting. Why? Because what central bankers
are truly concerned with - both for the purposes of internal deliberations and for
communications with the public - is the underlying rate of inflation going forward, and core
inflation can be a useful proxy for that rate. Thus, focusing on core inflation can help prevent
a central bank from responding too strongly to transitory movements in inflation.
Why monetary policy should focus on core inflation
Because households care about the prices of all the items they buy, it clearly does not make
sense to pretend that people do not eat or drive. Thus, I have no qualm in stating that
controlling headline inflation, not core inflation, is - along with maintaining maximum
sustainable employment - the ultimate aim of monetary policy. Nonetheless, I will argue that
it is still useful for monetary policy makers to focus on core inflation when deciding how to
respond to incoming economic news.
Although monetary policy is capable of controlling overall inflation in the long run, it does not
have the ability to control relative price movements such as those for food and energy. When
a cold snap freezes the Florida orange crop or a tropical storm hits the gasoline refineries
along the Gulf Coast, monetary policy cannot reverse the resulting spikes in prices for fresh
orange juice or for gasoline at the pump. Temporary supply shocks such as these raise the
prices of food and energy relative to other prices and can have substantial effects on inflation
in the short run. By including all items - including particularly volatile items like food and
energy - headline measures of inflation are inherently noisy and often do not reflect changes
in the underlying rate of inflation, the rate at which headline inflation is likely to settle and that
monetary policy can affect.
Measures of core inflation attempt to strip out or smooth volatile changes in particular prices
to distinguish the inflation signal from the transitory noise. Thus, relative to changes in
headline inflation measures, changes in core measures are much less likely to be reversed,
provide a clearer picture of the underlying inflation pressures, and so serve as a better guide
to where headline inflation itself is heading. Of course, if a particular shock to noncore prices
is not temporary but, rather, turns out to be more persistent, then the higher costs are likely
to put some upward pressure on core prices. Central bankers must always be aware of this
risk. However, research has shown that, over the past twenty-five years or more, headline
inflation in the United States has tended to revert more strongly toward core inflation than
core inflation has moved toward headline inflation.2 As that record suggests, core measures
often are much better than headline indexes at providing a first approximation of the
permanent changes to inflation.
When headline inflation has an important transitory component, a focus on core measures
can help avoid monetary policy mistakes. If the monetary authorities react to headline
inflation numbers, they run the risk of responding to merely temporary fluctuations in inflation.
We can think about this danger by considering a supply shock, that causes the relative price
of energy to increase sharply, as in fact has happened over the past three years. Let us
suppose that we start out with both headline and core inflation at acceptably low levels.
First, let's consider a supply shock that temporarily raises the price of energy by a large
amount. In this case headline inflation will rise well above its underlying trend as the price of
energy rises but will soon fall well below its underlying trend as the price of energy falls back
to its initial level. On average, inflation will remain unchanged without any monetary policy
2
These tests allow for a nonzero constant differential between headline and core inflation. The differential often
turns out to be nontrivial and statistically significant. Cogley (2002) uses published CPI over the period from
1967:Q2 to 1997:Q4 and finds that it may take about 8 quarters before there is substantial reversion of
headline inflation to core inflation. Clark (2001), using 12-month CPI inflation from 1967 to 2000 finds little
reversion over the next 12 months but about 50 percent reversion over 24 months, though that level is still
statistically insignificant. In contrast, he finds substantial and statistically significant reversion at both the 12-
and 24-month horizons using data from 1985 to 2000. Rich and Steindel (2007) find significant reversion of
headline CPI inflation to core CPI inflation over 12 quarters using methodologically consistent CPI data from
1978 to 2004. An earlier version of their work (Rich and Steindel, 2005) showed similar results using PCE
price inflation in the 1978-2004 and 1959-2004 periods. Internal work conducted at the Federal Reserve using
15-year rolling-window regressions suggests that the reversion of headline PCE inflation to core PCE inflation
has been much stronger in samples that start after the early 1980s and also that the reversion of core inflation
to headline inflation has been much weaker in that period.
Results for other countries are more ambiguous. In recent years, Canada appears to have had a similar
reversion of headline inflation to their version of core inflation, along with little reversion of core inflation to
headline inflation (Laflèche and Armour, 2006; also, Armour, 2006; Hogan, Johnson, and Laflèche, 2001).
However, the OECD (2005) has found that many countries show little reversion of headline inflation to core
inflation and that, in fact, core inflation often reverts to headline inflation.
BIS Review 118/2007
action. But a tightening of monetary policy in reaction to the rise in headline inflation would
lead to a decline in employment and inflation; and because of the long lags between
monetary policy actions and changes in economic activity, that decline would occur some
time down the road, when inflation would more likely be at or below its underlying trend. The
outcome of such a policy would be a more pronounced fall in inflation with a decline in
employment. Such a policy would be bad indeed because it would increase volatility in
inflation and employment, which is the opposite of what a central bank should be trying to
achieve as it seeks to promote price stability and maximum sustainable employment.
But what if a supply shock leads to a permanent shift in the relative price of energy? Indeed,
almost all commentators characterize the current oil price shock that way, in part because
they see the rise of new economic powers like China as adding to the demand for energy in
the foreseeable future. Although in that case the rise in relative energy prices is not reversed,
the rate of change in energy prices does not persist: Headline inflation will rise with the
increase in energy prices, but once energy prices reach their permanently high level,
headline inflation will revert to its underlying trend rate. Thus, as long as the permanent
change in relative energy prices does not lead to a change in the underlying trend rate of
inflation - a crucial assumption - then headline inflation will come back down again. This is
what we seem to have seen recently in the United States. From a low near $30 per barrel in
late 2003, the price of oil rose to $70 per barrel by the middle of 2006, and it has stayed high,
with the current price more than $80. That move increased headline PCE inflation to the 4
percent level for a time, but it has since retreated to around 2 percent (figure 1).
Monetary policy clearly can do little about the first-round effects of a permanent rise in
energy prices, which include both its direct impact on the energy component of overall
consumer prices and the pass-through of higher energy costs into prices of non-energy
goods and services. But policy does have a critical role to play in determining the
secondround effects associated with changes in the underlying trend rate of inflation. Such
secondround effects are likely to be quite limited as long as the rise in the relative price of energy
does not lead to a rise in long-run inflation expectations, as has largely been the case in the
recent period (figure 1). However, the stability of expectations rests on the central bank's
strong long-term commitment to providing a nominal anchor, which, as I have argued
elsewhere (Mishkin, 2007), describes the situation in the United States. With such a
commitment firmly established, monetary policy then does not need to respond as much to
the temporary rise in headline inflation to stabilize inflation over the longer run. Under these
circumstances, if monetary policy is tightened appreciably in the face of a surge in headline
inflation, the policy would likely be excessively tight and lead to an unnecessary decline in
employment.
Because the point about headline inflation is so important, I would like to illustrate it further
with simulations of FRB/US, the model of the U.S. economy created and maintained by the
staff at the Federal Reserve Board. To keep the experiments as clean as possible, I assume
that the economy begins at full employment and with both headline and core inflation at
desired levels. The economy is then assumed to experience a shock that raises the world
price of oil about $30 per barrel over two years; the shock is assumed to slowly dissipate
thereafter. In each of two scenarios, a Taylor rule is assumed to govern the response of the
federal funds rate; the only difference between the two is that in one scenario the funds rate
responds to core PCE inflation, while in the other it responds to headline PCE inflation.3
Figure 2 illustrates the results of these two scenarios. The federal funds rate jumps higher
and faster when the central bank responds to headline inflation rather than to core inflation,
as would be expected (top-left panel). Likewise, responding to headline inflation pushes the
unemployment rate markedly higher than otherwise in the early going (top-right panel), and
produces an inflation rate that is slightly lower than otherwise, whether measured by core or
headline indexes (bottom panels). More important, even for a shock as persistent as this
one, the policy response under headline inflation has to be unwound in the sense that the
federal funds rate must drop substantially below baseline once the first-round effects of the
shock drop out of the inflation data. Responding to headline inflation is therefore
inappropriate because it generates extensive variability in the unemployment rate - variability
that is much more subdued when policy responds to core inflation.4
Of course, the pitfalls associated with reacting to realized headline inflation, as illustrated by
this simulation, are well understood. Accordingly, advocates of targeting headline inflation
generally have in mind a strategy of responding to forecasts of headline inflation - forecasts
that try to take account of inflation movements that are likely to be transitory. This is a further
illustration of my basic point, namely, that it is important to distinguish between transitory and
persistent inflation movements, and focusing on core inflation can help achieve that end.5
The focus on core instead of headline inflation - and clear communication with the public
about that focus - can have another benefit: It may help anchor inflation expectations when
headline inflation increases temporarily but core inflation remains essentially unchanged. If
the public understands that the central bank is using core inflation in formulating monetary
policy and trusts that the central bank is right to do so, the public will realize that the central
bank does not need to respond aggressively to a surge in headline inflation to keep inflation
under control. And, with core inflation stable, the public will be less likely to think that the
central bank has weakened its commitment to a strong nominal anchor when it does not
tighten monetary policy to stabilize headline inflation. The result is that inflation expectations
are likely to remain anchored, which may lead to better outcomes not only on inflation but on
employment as well, because the central bank will not have had to tighten monetary policy
as much in response to the energy price shock. As I noted earlier, figure 1 offers some
support for this view: It shows that the rise in headline inflation in the 2004-06 period, when
core inflation remained quite stable, did not lead to an appreciable rise in long-run inflation
expectations, even with a substantial decline in unemployment during this period.
Is inflation excluding food and energy the best measure of underlying inflation?
The most popular core inflation measures used and published in the United States are quite
straightforward: They simply exclude changes in food and energy prices. However, such
simple "exclusion" measures can likely be improved upon. For example, many of the food
categories excluded in the standard measure of core inflation, such as food away from home
(restaurants), are not highly volatile and so likely should remain in an optimal core inflation
measure. On the other hand, some items that are not excluded from the U.S. core measures,
such as airline fares, tobacco, and apparel, are extremely volatile and thus are unlikely to be
included in an optimal core inflation measure.
The Bank of Canada, for example, uses a more targeted approach to its core inflation
indicator, the CPIX. Of fifty-four consumer product categories, it excludes eight, which
account for about 16 percent of the consumption basket (Macklem, 2001). Most of the eight
items are also excluded from the standard core measure in the United States. However,
Canada's CPIX also excludes intercity transportation and tobacco, which are included in the
U.S. core measures.6
Another approach to estimating core inflation measures is statistical, in which certain prices
are excluded at each point on the basis of statistical criteria. Among these statistical
measures are trimmed indexes, such as the trimmed mean and the weighted median
consumer price indexes produced by the Cleveland Fed and the trimmed mean PCE price
index produced by the Dallas Fed. Each month, these measures throw out the components
with the largest price changes, both positive and negative (though the Dallas measure is
asymmetric).7
Other approaches to estimating core inflation are theory-based measures employing
common trends, unobserved components, or a particular model of the economy.8 However,
these theory-based approaches tend to be rather complex and require faith that the model
they are based on is the right one.
Each of these measures of core inflation can be evaluated according to a variety of criteria,
including the ability to forecast headline inflation over some period and the degree of
correlation with alternative definitions of trend inflation. According to some of these criteria,
statistical and theory-based approaches are sometimes found to outperform simpler
exclusion measures of core inflation, like the standard one excluding food and energy. As
you can tell, this is an active area of research, but recent research done at the Federal
Reserve Bank of New York on U.S. data finds that no one particular core measure, including
the standard one, dominates the others: The relative performance of different core measures
varies depending on the choice of the price index, the sample period, and the criteria for
evaluating their performance (Rich and Steindel, 2007). Research on Canadian and U.K.
data comes to similar conclusions (Hogan, Johnson, and Laflèche, 2001; Mankikar and
Paisley, 2002).
Does the lack of empirical support for any one particular type of core measure suggest that
our focus on the standard core measure should be abandoned? I think not. The simplicity
and long history of the standard core measure that excludes food and energy gives it several
major advantages. Its simplicity makes it straightforward to explain and thus more
understandable to the public - assuming, of course, that we successfully communicate that
we recognize the importance of food and energy items in people's consumption. Its simplicity
also makes its estimation very transparent. That transparency and the fact that it has been
around a long time - hence the characterization as "standard" - both prevent a central bank
or a government authority from easily manipulating the measure to show good results. These
features of the standard core measure therefore make it a credible device to keep inflation
expectations anchored when supply shocks occur: If the standard measure remains stable,
then a surge in headline inflation is less likely to unhinge inflation expectations, which as we
have seen can lead to both better inflation and better employment performance.
Why central banks should also focus on headline inflation
Despite the advantages of core measures of inflation, their use in conducting monetary policy
has been criticized.9 Core measures of inflation attempt to remove the most volatile or
transitory components of the inflation measure. But, because the nature of price shocks may
change over time, items that have been highly volatile in the past may not be so in the future;
hence, any core measure will itself likely be subject to transitory shocks. Unfortunately, as
noted above, empirical research suggests that no one measure of core inflation will work in
all situations. Therefore, central banks do not focus solely on core inflation; rather, they
devote considerable resources to understanding inflation developments in an effort to
distinguish signal from noise in the incoming data.10
Another reason to keep watch over the broader inflation picture is that, if the rate of change
in the price of an excluded item receives a permanent shock, then the headline inflation rate
can deviate from the core measure for an extended period of time. The longer this period of
high headline inflation persists, the greater is the risk of second-round effects as the public
begins to build this higher inflation into its expectations. For example, from 1987 to 2002,
energy price shocks appear to have been temporary in that energy prices were mean
reverting; as a result, in this period, the average difference between core and headline PCE
inflation was quite small. Since 2002, however, the effect of energy price shocks have been
more persistent, and headline inflation has averaged more than 1/2 percentage point above
core inflation over this period. Over the past year, energy prices have about leveled off on
balance - or at least that was the case until a couple of weeks ago - and the rate of headline
inflation for most of this year has come down close to that for core, one hopes alleviating the
risk of second-round effects. But the increases in oil prices in recent days provide another
reminder that shocks can persist longer than one might have at first expected.
A prolonged divergence between core and headline measures of inflation could complicate
central bank communications with the public because core inflation would require some
adjustment before it would provide a clear gauge of underlying inflation. For example, the
weighted median CPI inflation rate, one popular measure of core inflation, has tended to be a
biased measure of headline inflation. The weighted median is exactly equal to owners'
equivalent rent nearly half the time because that component has an extremely large share of
the consumption basket and fairly low volatility (Bryan and Pike, 1991; Hogan and others,
2001; and Bryan and Meyer, 2007). However, the productivity growth rate in residential
construction is not terribly high, and so this sector is likely to have below-average productivity
growth and above-average price increases. Indeed, the weighted median CPI exceeded
overall CPI inflation on average by 1/4 percentage point per year over the decade from 1992
to 2002, a period when energy prices were transitory. Of course, to the extent that such a
bias in a core inflation measure is stable or predictable, the central bank could easily take
this into account in setting monetary policy. But even in that case, differences in average
rates of inflation between the core measure and overall inflation could complicate
communication with the public.
Conclusion
I have argued that a measure of core inflation that is easily understood and provides some
greater signal about persistent movements in inflation than does headline inflation itself is
extremely valuable for the conduct of monetary policy, and that is why the Federal Reserve
pays so much attention to such measures. However, I have also argued that core measures
have their limitations. A single core inflation measure cannot account for all types of shocks
and can at times be misleading about what is happening to the underlying rate of overall
inflation. And if increases in headline inflation prove more persistent than initially expected,
central bankers must be vigilant to ensure that they do not become embedded into
expectations and thereby generate substantial second-round effects on inflation. Finally,
because price stability ultimately involves control of overall, headline inflation, which after all
is the inflation measure that households really care about, central bankers should and do pay
attention to headline inflation as well as to core inflation measures. A core inflation measure
should not be seen as a substitute for thorough and careful analysis of the forces that are
driving our economy and the inflation process.
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