Core Versus Headline Inflation: An Opportunity for Greater Transparency

Abstract

T he core inflation measures—which exclude food and energy—are commonly used in monetary policy deliberations. Recently, the Federal Open Market Committee (FOMC) has been accused of being out of touch with consumers because the prices of groceries and gas have increased much more rapidly than the prices of the goods reflected in the core measures.1 In a recent speech, Janet Yellen, Vice Chair of the Fed’s Board of Governors, defended the FOMC’s use of core measures, saying that the Committee’s “focus on core and other inflation measures that may exclude recent increases in the cost of gasoline and other household essentials is not intended to downplay the importance of these items in the cost of living or to lower the bar on the definition of price stability.” Rather, she said, “The Federal Reserve aims to stabilize inflation across the entire basket of goods and services that households purchase, including energy and food,” but the FOMC focuses on core inflation measures because “in light of the volatility of food and energy prices, core inflation has been a better forecaster of overall inflation in the medium term than overall inflation itself has been over the past 25 years.”2 This essay notes that the evidence that core inflation is a better predictor of future headline inflation is mixed and presents the results of a simple test of the proposition that core inflation is a better predictor of future headline inflation than headline inflation. The essay concludes by showing that over periods of interest to consumers, the difference in the loss of purchasing power reflected by the core and headline measures is economically relevant. Not only is the evidence of the relative predictive power of the core versus the headline measures mixed, but much of the pertinent literature investigates the predictive power of core inflation measures that differ from those used by the FOMC.3 Consequently, surprisingly few studies address the hypothesis that core inflation used by the FOMC better predicts future headline inflation than headline inflation itself. In addition, much of the existing research uses a one-year forecast horizon, which is likely shorter than the “medium-term” horizon of interest to policymakers. Speci fically, I test whether the average level of core inflation or headline inflation over the most recent two or three years is a better predictor of headline inflation over the next two or three years.4 Twoand three-year forecast horizons are assumed to represent the “medium term.” I use a standard procedure to test whether the difference in the two forecasts is statistically significant in terms of either the mean square forecast error (MSFE) or the mean absolute forecast error (MAFE). Vice Chair Yellen did not specify a particular inflation index, so the analysis presented Core Versus Headline Inflation: An Opportunity for Greater Transparency