Neither core nor headline inflation measures can consistently and reliably predict medium-term inflation well enough to be of much use to policymakers.>Inflation (Finance) ; Monetary policy

Daniel L. Thornton

English

Research Papers in Economics

Economic SYNOPSES
short essays and reports on the economic issues of the day
2011 ■ Number 16
I
n a recent Economic Synopses essay, I questioned the
Federal Open Market Committee’s (FOMC’s) empha-
sis on core inflation measures that strip away food and
energy prices and provided some statistical analysis on the
relative ability of core and headline inflation measures for
predicting future headline inflation over the “medium term.”
(I defined the medium term as a horizon of two to three
years.) I also concluded that, for the period since the mid-
1980s, “there is no compelling evidence that core inflation
is a better predictor of future headline inflation over the
medium term.” I then suggested that “in the interest of
greater transparency and to allow the public to better
understand its focus on core measures, the FOMC should
provide evidence of the superior forecasting performance
of the core measure it uses.” My invitation was recently
accepted by my colleagues at the Atlanta Fed in their 
macroblog.
They analyze the predictive
power of core and headline CPI
inflation measures for the average
CPI headline inflation rate over
the next three years based on aver-
ages of core and headline inflation
over the past 1, 3, 6, 12, 24, and 36
months and show that the core
measures significantly dominate
the headline measures in predic-
tive accuracy at short horizons and
that forecasts based on the 3-month
core inflation measure is roughly
as accurate in predicting CPI infla-
tion over the next three years as
the forecast using the most recent
3-year average of headline inflation.
They come to the following
conclusions: “This observation
suggests that paying attention to
the core measure may allow you
to spot changes in the inflation
trend much more quickly than
using headline alone” and that
“the usefulness of a core inflation measure is best seen in
the monthly and quarterly intervals that span FOMC
meetings, not in the two- or three-year trends which are,
by construction, largely silent about the most recent data.”
I am pleased my colleagues extended my analysis because
it provides me with another opportunity to demonstrate
why I believe that core measures are not useful for conduct-
ing monetary policy.
The chart shows medium-term (3-year average) CPI
inflation since January 1985. It also shows the average level
of core CPI inflation over the prior three months and the
average level of headline CPI inflation over the prior three
years—that is, the 3-month core (3mc) and 3-year headline
(3yh) inflation forecasts. Three features of these data are
relevant: First, it is pretty obvious that neither the 3mc nor
the 3yh predicts medium-term CPI inflation very well.
Core Versus Headline Inflation Again
Daniel L. Thornton, Vice President and Economic Adviser
0
1
2
3
4
5
6
7
8
J
a
n
-
8
5
A
u
g
-
8
5
M
a
r
-
8
6
O
c
t
-
8
6
M
a
y
-
8
7
D
e
c
-
8
7
J
u
l
-
8
8
F
e
b
-
8
9
S
e
p
-
8
9
A
p
r
-
9
0
N
o
v
-
9
0
J
u
n
-
9
1
J
a
n
-
9
2
A
u
g
-
9
2
M
a
r
-
9
3
O
c
t
-
9
3
M
a
y
-
9
4
D
e
c
-
9
4
J
u
l
-
9
5
F
e
b
-
9
6
S
e
p
-
9
6
A
p
r
-
9
7
N
o
v
-
9
7
J
u
n
-
9
8
J
a
n
-
9
9
A
u
g
-
9
9
M
a
r
-
0
0
O
c
t
-
0
0
M
a
y
-
0
1
D
e
c
-
0
1
J
u
l
-
0
2
F
e
b
-
0
3
S
e
p
-
0
3
A
p
r
-
0
4
N
o
v
-
0
4
J
u
n
-
0
5
J
a
n
-
0
6
A
u
g
-
0
6
M
a
r
-
0
7
O
c
t
-
0
7
Percent
3-Year-Ahead Inflation
3yh
3mc
Medium-Term CPI and Core and Headline Inflation Forecasts
NOTE:  3yh, average headline CPI over prior 3 years;  3mc, average core CPI over prior 3 months.The root mean squared error (RMSE)—a measure of the
average distance from the forecast to the actual series being
forecast—is 1.06 percent and 1.04 percent for the 3mc and
3yh measures, respectively. This means that it is fairly likely
that forecasts of inflation over the next three years could
be off by a full percentage point or more. Given that the
FOMC’s inflation target appears to be about 2 percent, such
errors are very large relative to that target.1 Indeed, I believe
that forecasts that generate average errors this large are of
little use to policymakers.
Second, most of the advantage of the 3mc measure over
the 3yh measure occurs early in the sample period, when
there is a large persistent swing in medium-term inflation.
Since the early 1990s there have been no such swings in
inflation and the 3yh measure performs somewhat better
than the 3mc measure; the RMSEs since January 1994 are
0.98 percent and 0.79 percent for 3mc and 3yh, respective-
ly. Hence, neither measure is a consistently better predic-
tor of medium-term inflation.
The third thing to notice is that the 3mc forecasts are
very volatile. For example, the 3mc measure was just 0.20
percent in May 2003, suggesting that inflation would be
essentially zero over the next three years. However, just
three months later the 3mc measure was suggesting that
inflation would be nearly 10 times higher. Indeed, the
behavior of core inflation in early 2003 led the FOMC to
express concern about deflation that proved to be unwar-
ranted.2 Of course, this is not too surprising because a fore-
cast based on just three months of data does not average
out the “noise” in monthly data. It does suggest, however,
that 3mc may not allow policymakers to “spot changes in
the inflation trend much more quickly.”
There is essentially no difference between the best core
predictor and the best headline predictor. But let me re  -
emphasize my essential point: Neither core nor headline
inflation measures can consistently and reliably predict
medium-term inflation well enough to be of much use to
policymakers.3 Given that (i) neither can predict medium-
term inflation very well, (ii) differences between the core
and headline inflation measures have been relatively large
and very persistent, and (iii) consumers are at least as con-
cerned about food and energy prices as they are about other
prices that compose the index, it is difficult to rationalize
the FOMC’s preoccupation with core measures. The pre-
occupation with core measures would makes sense only if
core measures consistently and accurately forecast medium-
term inflation. It appears that no measure does this con-
sistently and accurately.4
I believe that policymakers should pick an index that
they believe best reflects inflation. (I believe that the CPI
is sufficient for that purpose; moreover it is a widely used
index for public and private contracts, etc.) And monetary
policy should be conducted based on the behavior of this
index. Specifically, when this inflation measure moves per-
sistently above or below the policymaker’s inflation objec-
tive, they should tighten or ease policy, respectively. As I
noted in my previous Economic Synopses essay, the FOMC’s
preoccupation with core inflation may have resulted in a
higher average rate of inflation: Core CPI inflation averaged
2.02 percent over the past decade, while headline inflation
averaged 2.67 percent—a difference that nears a full per-
centage point above what appears to be the FOMC’s infla-
tion objective. ■
1 See the transcript of Chairman Bernanke’s first press conference at 
www.federalreserve.gov/monetarypolicy/fomcpresconf20110427.htm.
2 For a discussion of the FOMC’s concerns and their effect, see Thornton, Daniel L.,
“The Lower and Upper Bounds of the Federal Open Market Committee’s Long-
Run Inflation Objective,” Federal Reserve Bank of St. Louis Review, May/June
2007, 89(3), pp. 183-93.
3 To get some insight into how small the RMSE would have to be to be useful for
policy purposes, assume that that forecasts are unbiased, so the RMSE represents
the standard deviation of the forecast error. Further assume that the forecast errors
are normally distributed. Now assume that the FOMC has a medium-term infla-
tion objective of 2 percent and that policymakers will consider their efforts success-
ful if during the medium-term period the average inflation rate does not deviate
from the target by more than half a percentage point. Assuming that policymakers
respond appropriately and that policy actions are effective over the medium-term
horizon, the RMSE would have to be no larger than 0.25 percent for policymakers
to achieve their policy objective with a high degree of certainty. If policymakers
wanted to be very certain of achieving their objective, the acceptable RMSE error
would have to be much smaller. It would also have to be smaller if the acceptable
error was less than half a percentage point, policy actions were less effective, or
policymakers did not respond appropriately.
4 Jon Faust and Jonathan H. Wright (“Forecasting Inflation,” unpublished manu-
script, May 23, 2011) find that very few of the wide variety of inflation forecast-
ing models that they consider generate out-of-sample RMSEs much below 1.0
percent—and none below 0.70 percent.
Economic SYNOPSES Federal Reserve Bank of St. Louis      2
research.stlouisfed.org
Posted on June 9, 2011
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
Neither core nor headline 
inflation measures can consistently
and reliably predict medium-term
inflation well enough to be of 
much use to policymakers.

Core versus headline inflation again

http://research.stlouisfed.org/publications/es/11/ES1116.pdf

Core versus headline inflation again

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics