In moments of crisis, the advantages derived from economic stability can be better appreciated. The behavior of inflation is a case in point. A representative comment goes: “when the headline CPI is higher than the CPI-core for many months, you can bet that inflation in the CPI-core is around the corner”. In “A turning point for core” (Aug 14), James Picerno argues that “yesterday´s update on consumer prices could hardly send a clearer message: pricing pressure is rising, and it´s no longer just about energy…”.
But is this so? During the “Great Inflation” (1965 -1980), a relative price shock (the oil shocks of 1973 and 1979) quickly turned into an increase in “core” inflation. While it is true that many inflationary episodes started off with a relative price shock that need not be true, requiring that the Fed accommodates the (relative price) shock.
Figure 1 clearly shows the difference in the behavior of inflation following a relative price shock. It compares what happened to core inflation in the fifteen years from 1965 to 1980 and the outcome observed in the last fifteen years.
The energy shocks in the most recent period is stronger and more persistent than the ones occurring in the 1970´s but has had no apparent effect on (core) inflation. So that there is no doubt about the magnitude of the shocks that hit the economy, figure 2 displays the real price of oil in the two periods.
Yes, nowadays the US economy is much less dependent on oil. But also, monetary policy is very different from what it was back then.
Figures 3 and 4 clearly illustrate this point. While during 1965 -1980, a “shock” or disturbance to headline inflation (following, for example, a rise in the price of oil) would significantly and persistently raise the core measure, in the most recent period a shock of comparable magnitude to headline inflation does not propagate to the core index. More generally, many argue, based on the “production-chain” logic that shocks to producer prices (PPI) will in time propagate to core consumer prices. The figures are illustrations of “impulse-response functions”, describing how a disturbance in the headline consumer price index or in the PPI affects the core consumer index over time (months ahead). If the dotted lines encompass the zero line, there is no “pass-through” to the core index. This seems to be the case in the most recent period.
Many also argue that the greater inflation (and output) stability observed since 1984 is to a significant degree due to luck (associated with more benign shocks). Maybe economic policy in general and monetary policy in particular has had a more important contribution to the reduction in macroeconomic uncertainty and the amplitude of cycles.
In any case, the greater economic stability experienced over the last twenty five years allows the Fed the luxury to attend to the “dead and wounded from the financial tsunami” without running unduly large risks that inflation will “blossom” from increases in the prices of energy, food and commodities.