Larry Meyer quoted in The Economist’s Free exchange blog post about the importance of core inflation (general prices excluding energy and food prices). He argues that headline inflation tomorrow will converge to core inflation today. So, it is important to also focus on core inflation today to see where headline inflation will go in the future:
“Why do we, as forecasters, and the FOMC in its own forecasts, focus on core inflation? The question should not be whether I buy groceries and gas, but whether headline or core inflation is a better measure of where headline inflation is likely to settle once overall prices have adjusted to the higher prices of energy and food. As forecasters, we want to know not only what (headline) inflation is today, but also, and much more importantly, where headline inflation is likely to be tomorrow (the medium term). Identifying a measure of underlying inflation gives us a good head start...
Our thesis, and the FOMC’s position, is that headline inflation converges to core, that is, headline inflation tomorrow will fall towards core inflation today. Whether or not this is a valid thesis is an empirical question...If you test whether higher oil prices raised core inflation over the 1970s and early 1980s (or in samples that include this period), the answer is a definitive “Yes” (higher oil prices pass through to core inflation). In this case, core inflation tomorrow will converge to headline today. However, if you test this hypothesis over the subsequent period, from the mid-1980s to today, the answer is “No” (no pass-through). In this case, headline tomorrow will converge to core today. This is the basis for our forecasts...
The Fed has built credibility over the last two decades: Long-term inflation expectations are stable, have been stable for more than a decade, and are likely to remain so. 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 generalized increase in prices, today or tomorrow. So the critical question is whether inflation expectations are well anchored today—we believe that they are—and, more importantly, whether they are likely to remain so...”
