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Federal Reserve: Getting To The Core Of Things

Posted by MICHAEL SILVERSTEIN, Wall Street Columnist in Economy, Health, Society.
Apr 28th, 2008 | Comments

Rising food and energy prices are scaring a lot of people. Not the folks at the Federal Reserve, though. They have found a revolutionary mechanism to address worries generated by these price increases. By creating its own preferred inflation measure, the so-called core rate, which factors out food and energy, the Fed can claim inflation is well under control.

Given that food and energy are core elements in sustaining human life, I used to be bothered by this curious approach to economic management. Now that I view the matter from a broader perspective, however, I see many valuable applications in other realms.

Take medicine, for example. Lots of people have cancer and heart disease. But a core rate of health, one that excludes these maladies, would improve our national health statistics dramatically at no extra cost to anyone.

In a related vein (so to speak), by excluding these unpleasant medical realities along with, say, diabetes and alzheimers as causes of death, the average American lifespan would be 102.6 years. And all without any more dieting or exercise. Yippee!

The weather. Boy, can that ever put people out of sorts. So why not just exclude temperatures over 80 degrees and under 70 degrees to get a core temperature of 74 degrees that’s reported on the local news every evening?

Crime! Poof!. Exclude murder, rape and assault from reporting of violent crimes, call what’s left the core crime rate, and there is no violent crime. Think of the money this will save on local police budgets.

Everything is beautiful when everything that isn’t is excluded. Thank you Chairman Bernanke for showing us the way. One thing, though. Could you loan me half a tank of gas and a couple of eggs until payd

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runasim

The thing about numbers is that you can move them around to prove almost anything. You have to know and understand the methodology to have a prayer of a chance to understand what some statistics mean.

Reagan's administration introduced a new way to measure unemployment, and, voila!, our unemployment rates dropped dramatically! Current rates are only good for comparing to last year or last month, etc. No one knows what our actual unemplyment rate is.

Also, we can't compare out unemployment rates to Europe's, because they use a different, incompatible, methodology.

The confusion makes statistical figures very secuctive tools for political manipulation.

yetanothermoderatevoice

What you say may be true, although an alternative explanation might be that:

1. The Fed has a dual mandate to promoting full employment and price stability (http://www.federalreserve.gov/newsevents/speech...)
2. The Fed's actions can be seen in terms of a control system to stabilize the economy (http://en.wikipedia.org/wiki/Control_theory)
3. Using the terminology in that article, the "reference sensor" must measure something in order to "close the loop".
4. Even in a purely deterministic context with no lags or uncertainty about the effects of policy, the choice of an inflation measure that captures overall inflation is not obvious (http://en.wikipedia.org/wiki/Laspeyres_index).
5. Monetary policy operates in a stochastic context with long and variable lags
6. Historically, food and energy prices have been much more volatile than most other prices, but not appreciably different in long trend.

Therefore a system whose intent is to reduce painful swings in unemployment and inflation could, in principle, have better outcomes by using core rather than headline inflation.

I'm no specialist, but this narrative makes some sense to me since there are lots of things that have to be managed (e.g. relationships) where you may to decide to ignore fluctuations of some indicators (e.g. mood swings) and focus on more persistent trends. It's not a matter of manipulating statistics to show what you want (as runasim says), it's a matter of *choosing* informative statistics to help guide you.

mikkel

Michael, I'm not sure why you made it sound like Bernanke was responsible, since I believe that CPI measures haven't changed since Clinton. The current measure was a highly political move since social security payments are tied to it, and there is widespread agreement that was a driving factor in the changes.

yetanothermoderatevoice:
While what you say is true, the entire basis for excluding food and energy relies on the volatility being zero mean. While food and energy vary widely from month to month, when there is a a very steady increase as there has been for the last 5+ years, then there is absolutely no intellectually honest foundation to exclude them entirely.

There are a couple ways they could accurately incorporate the categories. They could either have a moving average calculated over the last six months; they could have a seasonally adjusted number; they could have a YOY adjustment.

I also think it's pretty clear that the current statistics are severely flawed. If you look at the old unemployment number calculation or the inflation numbers, then the last 8 years have been horrendous, and the general mood about the economy is much closer to those numbers. Even the 90s weren't nearly as good as the headline statistics looked like. I don't think manipulating statistics enhances the efficacy of the Fed's actions, and indeed encourages it to adopt policies that encourage non-efficient investment.

I don't think it's a coincidence that the Fed felt like they had political cover to reduce down to 1% during the first recession with the new inflation calculation or that a historical bubble formed from those actions.

yetanothermoderatevoice

mikkel: "the entire basis for excluding food and energy relies on the volatility being zero mean"

I assume you mean that the mean of food - core or energy - core is zero mean - i.e. you can consider headline inflation = core inflation + error term, where the error term is zero mean.

The econ blogs I read (e.g. EconBrowser, EconomistsView, VoxEU, Brad deLong) have discussed this, and there have been opinions expressed by all sorts of big names about the change in dynamics of food prices and energy, and they have expressed similar concerns. My sense is that "everybody" is seriously wondering about whether or not there has been a sea change in the role of energy and food, and whether or not core CPI ought to be replaced with headline, but there is not definite consensus that it should.

I also agree that some statistics out there are pretty misleading. While there has been reasonable GDP over the last year, what also seems to be true is that median real wages have stagnated for about eight years, while at the same time the uncertainty surrounding future income, future retirement security, and future health insurance, has dramatically increased. So the median person, looking forward, cannot feel too good about things.

mikkel

yetanothermoderatevoice, yes that's exactly what I meant. That is the explicit rationale that the government used to remove it (again, it's not the Fed but various executive departments that release statistics for any one that's wondering).

Also, I have to state that I often disagree with the major economist viewpoints. They basically assume that constant expansion of debt will solve things, and be accompanied by wage inflation and that no bubbles will occur. Obviously this isn't the case. (I'll never get over when Brad deLong wrote "I have never been able to make this "overproduction" argument make sense. If the government provides a subsidy--like a mortgage insurance subsidy--then we will indeed have more of whatever the government subsidizes, but there is no reason to think that this is in any way a big problem or an unsustainable situation.") Inflation -- and its proper computation -- is an entirely different beast depending on your base assumptions.

Like your last paragraph points out, the popular statistical measures don't necessarily reflect the situation for the "average" (median) person.

Slamfu

Sounds to me like the Bush adminstration is just padding its numbers again to make things seem rosier than they are. This is the misleading kind of faux leadership manuver that trashes companies like Enron, and if we keep it up, the US. There is no profit to be had in ignoring reality unless you are a con artist trying to pull something on someone. .

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