-- =DJ BIG PICTURE: Trust In Core CPI Inflation Is Misplaced
By John McAuley
A DOW JONES
NEW YORK (Dow Jones)--In this era of
sky-high oil prices it's common to see a
headline about an uncomfortably
large increase in prices soothingly explained as
a minor blip since the core
price index wasn't really affected.
The market's allegiance to the
core inflation number, broadly defined as the
Consumer Price Index without
the more volatile components such as food and
energy, is understandable. Wall
Street economists as well as investors prefer
the smoother picture
represented by the core CPI number.
However, there are a number of
reasons why the markets' faith in core
inflation is at least misplaced and
possibly risky - certainly as a monetary
thing, there is the usual protest that food and energy prices are
consumer expenditures and sharp hikes in gasoline or food prices
certainly noticed by consumers who may change spending habits as a
These goods fall into the class of necessities, the kind of
would buy regardless of price. The more consumers pay for
these goods, the less
they will spend on other purchases.
another reason why the fascination with the core may be misplaced.
The core is hardly a pure number, and the reason has to do with an
that government economists use to capture the cost of home
concept is called owners' equivalent rent and is derived by
on what they would be willing to pay exclusive of
utility and fuel costs to live
in their homes.
that when fuel and utility costs go up, owners' equivalent
rent goes down, a
relatively simple and intuitive conclusion, but one not
captured in the core
CPI. This is important to note because the concept of
owners' equivalent rent
accounts for some 22% of the total CPI and 29% of the
barrel of crude oil hovering above $65, some economists argue that the
on core CPI is felt through the owners' equivalent rent.
There is a
"perverse interaction between high utility prices and owners'
rent," notes Richard Iley, senior economist at BNP Paribas in New
Iley explains that the owners' equivalent rent concept is imputed,
actually measured. The perversity creeps in because if fuel
and/or gas and
electric utility prices are shooting up, homeowners will tend
to lower the rent
they would charge.
However, that's not the way
it really happens among apartment renters, who
typically pay higher rent as
fuel and utility prices rise.
"If owners' equivalent rent
`normalizes' back to its long-run average of 3%
(up 2.5% year-over-year in
December) and the Fed wants to stabilize overall core
CPI inflation at around
its well-documented tolerance threshold of 2%, then the
remaining 70% of the
core can only run at just above 1.5%." He estimates that
the concept is
currently running at about 2%, so the Fed will have to squeeze
the rest of
the CPI core much lower to accommodate and increase in owners'
The Roots Of The Core Concept
A recent paper by two economists at the Federal Reserve
Bank of New York,
Robert Rich and Charles Steindel, "A Review of Core
Inflation and an Evaluation
of Its Measures," credits the late Otto Eckstein
of Harvard and Data Resources
and Robert Gordon of Northwestern University
with developing the concept in the
The Bureau of
Labor Statistic began to report both the CPI and the producer
excluding food and energy in 1978.
The use of the core CPI concept as
an economic target by the Federal Reserve
evolved during the 1980s and became
an early favorite metric by Fed Chairman
Alan Greenspan during his tenure.
There was a quite reasonable underlying rationale for focusing on the
rather than total headline inflation. Food and energy prices were
determined by supply-driven forces outside the control of the Fed:
crops in the case of food, the Organization of Petroleum
Exporting Countries in
the case of energy. By contrast, the core prices were
more demand-driven and
therefore more vulnerable to a monetary policy
But the linkage between fuels and utilities to owners'
equivalent rent means
that the core concept is contaminated by an energy
Calls To Can The Core
"It's perverse for the BLS to show owners' equivalent rent going down
fuel and utility prices rise," said John Silvia, chief economist at
Securities in Charlotte N.C. He believes that "we should can the
Most important, is the danger that arises from focusing on the
"It's a risk for monetary policy to focus on the core because
there's a danger
that it will miss a key development," said John Lonski,
chief economist at
Moody's Investors Service in New York.
(John McAuley, a special writer who covers the economy for
Newswires, is a former Wall Street economist. He holds a Ph.D. in
trade and macroeconomics and has been teaching economics at
-By John McAuley, Dow
Jones Newswires, 201-938-4425; firstname.lastname@example.org