- The Washington Times - Sunday, March 11, 2007

In economics, sometimes believing makes it so. When people are optimistic about the economic outlook, they behave in ways that help realize their expectations.

If consumers are confident about their future incomes and don’t foresee higher taxes or inflation, they are more willing to make spending commitments. The stronger demand for goods and services in turn stimulates business investment, job creation, and wage growth, further fortifying economic optimism. Pessimism about the future can be similarly self-fulfilling.

Economic expectations are influenced by personal experience, past trends and forecasts. Especially influential are the forecasts made public by the Federal Reserve’s policymaking open market committee (FOMC).

Take inflation. When the FOMC forecasts continued price stability, it is influencing the public’s expectations and behavior in a way that helps to assure that outcome. Optimism has its payoffs. If inflation were to get away from the Fed and policymakers to lose credibility, expectations of worsening inflation could trigger behavior that would contribute to bringing about that result.

Twice a year the Fed chairman presents to the Congress the FOMC’s economic forecast for the current and following year, which includes the committee’s prediction of inflation. In the last seven years, the FOMC has twice changed the inflation measure used in its forecasts, both times shifting to a tamer inflation series.

In the years prior to 2000, the FOMC forecast the overall, or headline, Consumer Price Index (CPI). In early 2000, during rising inflation, the FOMC shifted from the CPI to forecasting the more subdued overall personal consumption expenditure (PCE) price index. During the 1990s, the PCE inflation rate had averaged about a half point less per year than the CPI inflation rate, not a small amount.

The explanation for the switch was relegated to a footnote in the Fed’s report to Congress, though the reasons given were substantive: The CPI was upward biased because it used fixed weights, whereas the PCE inflation rate reflected the changing composition of spending, was a more comprehensive measure, and was more consistent over time.

The second change came in mid-2004, again when inflation was rising. The FOMC switched from forecasting the total PCE to forecasting core PCE inflation, which excludes food and energy prices, some of which are volatile and can distort the trend in underlying inflation. In the decade prior to the change, the core PCE inflation rate had averaged about a half-point less a year than the total PCE rate.

Since the 2004 change, the difference has widened to nearly a percentage point, reflecting the sharp rise in energy prices.

The brief explanation given for the change was that the FOMC “believes [the PCE inflation rate] is better as an indicator of underlying inflation trends than is the overall PCE price measure previously featured.” A skeptic might wonder if the Fed was ratcheting down its inflation measure to help keep inflation expectations in line.

To be sure, there were sound arguments to support the Fed’s choice of the core PCE measure. Insofar as monetary policy has limited effect on energy and food prices, some economists believe it makes sense to exclude them. The exclusions are also said to improve forecasts of the headline inflation rate, thus enabling policymakers to get an early look at developing price trends.

On the other hand, there are good arguments against switching to a core inflation index. There are those who say that, after all, we do buy food and energy, so policymakers should concentrate on headline inflation. Also, some say, it’s a mistake to exclude price components which have short-term variability if they also have an above-average or below-average trend. There are statistical techniques that can preserve the trend and discard the noise in the data, like the refined inflation measures calculated by the Federal Reserve banks of Dallas and Cleveland.

Stephen Cecchetti, a Brandeis professor and former executive vice president and research director at the New York Fed, minces no words, saying core inflation measures are misleading. In the Financial Times last September he wrote that “policymakers… should turn their attention to forecasts of headline inflation and stop focusing on core measures.”

Central banks in Europe put greater emphasis on headline inflation than does the U.S. Fed, reflecting a view that energy prices may be on a long-term rising trend as a result of rapid growth in the Chinese and Indian economies.

Charles Bean, chief economist of the Bank of England spoke out on the issue at a conference last summer sponsored by the Kansas City Fed: “The fact that the rise in oil prices is the flip side of the globalization shock to me renders highly suspect the practice of focusing on measures of core inflation that strip out energy prices while retaining the falling goods prices.”

Alfred Tella is former Georgetown University research professor of economics.



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