-- =DJ BIG PICTURE: Trust In Core CPI Inflation Is Misplaced --

   By John McAuley
   A DOW JONES NEWSWIRES COLUMN

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
policy target.
For one thing, there is the usual protest that food and energy prices are
important consumer expenditures and sharp hikes in gasoline or food prices are
certainly noticed by consumers who may change spending habits as a result.
These goods fall into the class of necessities, the kind of products consumers
would buy regardless of price. The more consumers pay for these goods, the less
they will spend on other purchases.
There is 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 assumption
that government economists use to capture the cost of home ownership. The
concept is called owners' equivalent rent and is derived by surveying homeowners
on what they would be willing to pay exclusive of utility and fuel costs to live
in their homes.
Economists believe 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
core.
With a barrel of crude oil hovering above $65, some economists argue that the
impact on core CPI is felt through the owners' equivalent rent.
There is a "perverse interaction between high utility prices and owners'
equivalent rent," notes Richard Iley, senior economist at BNP Paribas in New
York.
Iley explains that the owners' equivalent rent concept is imputed, rather than
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'
equivalent rent.

   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
1970s.
   The Bureau of Labor Statistic began to report both the CPI and the producer
price index 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 core
rather than total headline inflation. Food and energy prices were largely
determined by supply-driven forces outside the control of the Fed: weather and
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 response.
But the linkage between fuels and utilities to owners' equivalent rent means
that the core concept is contaminated by an energy effect.

   Calls To Can The Core

"It's perverse for the BLS to show owners' equivalent rent going down when
fuel and utility prices rise," said John Silvia, chief economist at Wachovia
Securities in Charlotte N.C. He believes that "we should can the core."
Most important, is the danger that arises from focusing on the core.
"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 Dow Jones
Newswires, is a former Wall Street economist. He holds a Ph.D. in international
trade and macroeconomics and has been teaching economics at Fordham University
since 1974.)

-By John McAuley, Dow Jones Newswires, 201-938-4425; john.mcauley@dowjones.com