Estadistica y Sociedad: Inflation

Core principles

Jun 21st 2007
From The Economist print edition

Bond investors are living in a world where nobody eats or drives

DO THE financial markets believe that the typical American consumer is on a permanent fast, walks everywhere and survives without heating or air conditioning? After a jittery few weeks, bond markets rallied on June 15th on news that America's core consumer price index rose by just 0.1% in May. The data were warmly greeted by stockmarkets too. The Dow Jones index rose by 86 points on the day. Investors decided that the absence of price pressures would calm the nerves of rate-setters at the Federal Reserve, who have been worrying out loud about "elevated" core inflation.

What the markets blithely ignored was the day's bad news. Headline consumer prices rose by 0.7%, the biggest monthly increase for nearly two years. Unlike core inflation, the headline measure includes fuel costs, which rose sharply, as well as food prices. For bond prices to rise on such a big jump in inflation, markets must be placing a great deal of faith in the core index as the true gauge of price pressures. Is that wise?

The cold-and-hungry index

The lure of core inflation as a barometer is that headline inflation rates tend to be volatile. Last June the annual headline rate in America, pushed up by soaring oil prices, was as high as 4.3%, but by October it had plunged to 1.3%. The rationale for excluding food and fuel is to filter out prices that jump around for temporary reasons, such as the vagaries of the weather or the messy politics of the Middle East. A good core index excludes this noise, leaving only the enduring part of inflation that reflects the weight of spending in the economy.

Despite these statistical merits, there are several reasons not to rely blindly on core measures. First, the elements that the core index excludes are likely to pick up lasting shifts in inflation pressures earlier. Food and petrol are frequent purchases and their prices tend to be less "sticky" than those for more durable goods. Rising retail food prices can sometimes signal general price pressures. They are also a strong influence on perceptions of inflation, because consumers encounter them so frequently.

Second, the core and volatile elements of inflation are not entirely independent. Increases in food and energy costs can squeeze spending on other goods and services, depressing prices and artificially lowering core inflation. That is the reason why Mervyn King, the Bank of England's governor, referred in a speech earlier this month to the practice of excluding price categories as "highly misleading".

Third, core measures tend to stress the disinflationary supply-side of globalisation, but play down the inflationary pressures on demand. The integration of China and India into the global economy has led to lower prices for manufactured goods, trimming core inflation rates. But there is a sting in the tail: rapid growth in emerging economies has pumped up global demand for primary resources and boosted commodity-price inflation—not just in oil but in food too (see article). When these pressures are sustained, as they have been, core measures will under-represent true inflation.

The truth is that no index is perfect (there is a long argument to be had about whether housing costs are properly measured in the core number as well). What matters most are what real consumers spend their money on—and how they react to the prices of those things. Core measures are certainly useful if they can efficiently strip out price changes that are likely to prove fleeting, without losing track of underlying inflation. But investors should remember that they are never all you need to know about inflation. Unless, of course, you live in a world without cars, air conditioners and cornflakes

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