Don't Worry About Inflation
The Federal Reserve is facing a major challenge because high commodity prices, especially oil, have produced high headline inflation. But the Fed should not overreact.</br></br>The Consumer Price Index (CPI) last month rose more than 5% over a year earlier, way above a rate that is consistent with price stability. At the same time, the federal-funds rate is at 2%, so the real interest rate on federal funds -- the interest rate adjusted for inflation -- has turned very negative.</br></br>Will this low real interest rate lead to inflation spiraling out of control? Shouldn't the Fed react more to the currently high inflation numbers by tightening policy, a view often advocated on this page, or at least not further lower the fed-funds rate if the economy looks like it might go into a tailspin? The answer is no.</br></br>It is certainly true that central banks should be worried about high headline inflation caused by high commodity prices. After all, households daily pay for energy and food items, and they are a big chunk of people's budgets. But central banks cannot control relative prices 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 that lead to high inflation in the short run. Particularly volatile items like food and energy, which are included in 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 which monetary policy can affect.</br></br>This is why the Fed pays attention to measures of core inflation, which attempt to strip out or smooth volatile changes in particular prices to distinguish the inflation signal from the transitory noise. 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 turns out to be more persistent, then the higher costs are likely to put some upward pressure on core prices.