Sunday, October 21, 2007

What's Wrong with Core CPI?

Bernanke says the following in a recent speech:

"[A]lthough energy prices have been volatile, indicators of the underlying inflation trend, such as core inflation, have moderated since the middle of last year."

Yes, central bankers are watching core CPI at 2.3 percent, more closely than CPI itself, which is at 3.6 percent. (Source.) I disagree with their assumption that core CPI is a more valid measure of price movements and hence of the soundness of monetary policy.

Aren't they forgetting a principle of economics? As Milton Friedman has pointed out several times, people have a fixed amount of disposable income, and they can save some of it (at the moment, there is very little saving going on), or spend it. This means that the disposable income spent on stuff like gasoline, computers, health services, clothing, entertainment, etc., is a zero sum game.

In other words, when gas prices rise, and unless a consumer decides to cut down on gas consumption--and he doesn't always have this choice, he'll have to spend more on gas and will then have less to spend on other things (the core CPI items), which will put downward pressure on the price of those items.

If the Fed is reading core CPI instead of CPI, they are reading a distortion, i.e. only half of the story, without taking into consideration the pressure from the other half.

How easy was that? I just shot a hole through our Federal Reserve's monetary policy.

dartboard
[Thanks to winsdartboards.com for the image.]

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