The Fed and Energy Prices

There has been a simmering debate about whether the Fed is focusing on the right measurement of inflation. The Fed prefers to use core Personal Consumption Expenditure (PCE) in its Taylor Rule. Economists use core PCE to eliminate "noise" from the data. They do this by stripping out volatile food and energy prices, which the Fed has no control over. Critics like Barry Ritholtz like to call this "inflation ex-inflation", since the headline inflation numbers which include food and energy have shown higher inflation. Thus in the great inflation debate you argue either for the core or the headline inflation data. The key questions are:

Should a central bank accomodate energy price shocks? Should the central bank use core inflation or headline inflation with the volatile energy component in its Taylor rule?

These are the questions that two economists -- Rajeev Dhawan and Karsten Jeske -- at the Federal Reserve Bank of Atlanta set out to answer, most likely in response to clamoring in the media that the the Fed was ignoring the average American consumer by ignoring food and energy prices. So what did Dhawan and Jeske conclude in their paper entitled "Taylor Rules with Headline Inflation: A Bad Idea." (I guess the title kind of gives it away . . .)

• While the central bank cannot completely shield the economy from an energy price spike, a monetary policy that responds to core inflation does better than one that responds to headline (total) inflation.
• The less weight given to energy inflation, the lower the impact of an energy price shock on GDP and subsequent inflation. In fact, the central bank can lessen the impact of such a shock by assigning a negative weight to energy inflation, so long as it remains vigilant on core inflation.
• Rebalancing between durable goods and fixed capital investment is key in explaining this unconventional wisdom.
• Results vindicate the claim of Bernanke, Gertler and Watson (1997) that a less aggressive response by the Federal Reserve to the energy price increases of the 1970s would have stabilized inflation without harming economic growth.

It seems the academics are not flinching from their stance that the core numbers are the more important numbers to focus on. Take that Barry Ritholtz! (Hat Tip: CXO Advisory)