In the first four months of this year the Consumer Price Index (CPI) was rising at a 4.8 percent annual rate. The Federal Reserve and most economists, however, weren’t overly concerned because the CPI’s core rate of inflation (or "the closely watched core rate" as it is now usually rendered in economist speak) was rising at a far more modest 2.7 percent in this same period.
Why is this core rate, which excludes changes in food and energy prices, rather than the far more inclusive CPI, now the main focus of inflation’s rise and fall? You might well wonder.
No one, after all, not even an economist, lives in a core rate world. No one can stop spending on energy and food one month because their prices are going up too quickly. To separate out two components of the CPI and claim the remainder is a "more accurate gauge of underlying inflation" thus misrepresents real world spending. And by-the-by, over time, may generate a dangerous cynicism about official statistics generally.
The rationale economists use to justify focusing on the core rate is most curious. Why trim out energy and food, which together account for about a quarter of the total CPI, because they are said to be "volatile," when every component of the CPI is volatile from time to time. Should we not take into account a sharp rise in health care costs or housing costs or clothing costs one month because such numbers are "volatile"? Would such an approach lead to a more accurate guide to inflation?
Indeed, singling out food and energy for exclusion in this way has been questioned by the Fed itself. In a 1997 Economic Letter put out by the Federal Reserve Bank of San Francisco, it was noted that "...not all food and energy prices are volatile, and not all volatile prices are in the food and energy sectors...Several price series that are included in the core CPI were at least as volatile as the food and energy price series...{I]f the aim is to construct a CPI series that excludes volatile items, removing all energy and food items may not be the best way to proceed."
One reason the Fed and so many private economists choose to proceed down this road is because they honestly believe it "smooths out" inflation numbers by ignoring two CPI components that do, in fact, often show month-to-month volatility. But why bother when a smoothing is done by the CPI itself over time? You take any 12-month period and compare it with the proceeding 12-months, and you have a smoothed out view of inflation’s rise or fall. Why throw core rate into the equation?
There is, however, a more sinister reason why the Fed and many economists may prefer to focus on core rate rather than CPI inflation numbers. Even though the very word "volatility" suggests that things fall as rapidly and as often as they rise, that’s not the case here. For the first 4 months of 2005, according to the Bureau of Labor Statistics, CPI rose at a 4.8 percent pace while the core rate rose at a 2.7 percent pace. For all of 2004, the CPI rose 3.3 percent compared to a 2.2 percent core rate increase. Indeed, since 1996, the core rate of inflation has exceeded the CPI just two years out of ten. Which is to say, if one were disinclined to take the economically painful steps to check an unacceptable level of inflation, these steps could more easily be avoided by taking a core rate view of inflation.
Mark Twain once noted that "there are lies, damn lies and statistics." The problem with substituting the core CPI numbers for full CPI numbers is not that that both or either are lies or even damn lies, but that doing so can easily lead to not addressing real world inflation problems before they spiral out of control.
© Michael Silverstein
