Can Food and Energy Prices Affect Future Inflation?

Over the past several months food and energy prices have been soaring. Americans have likely noticed these changes at the grocery store and at the pump. In the meantime, the Federal Reserve has been conducting monetary policy explicitly intended to increase inflation. That causes some people to complain, saying that prices are rising quickly enough without the Fed's help. In a New York Times op-ed today, former Fed governor Laurence H. Meyer argues that we shouldn't worry about food and energy prices, because they don't have much impact on long-term inflation. That is true, but does this rule always hold?

Meyer says that core inflation -- which measures how much prices rise excluding food and energy -- is the right measure for the Fed to pay attention to. It has historically provided a better sense of longer-term inflation trends, due in large part to the relative instability of food and energy prices. He explains why:

Since the inflationary era ended in the early '80s, the Fed has earned a reputation for keeping inflation in check. For more than a decade, the markets have operated under the assumption that in the long term inflation will be stable. This means that spikes in food and energy prices do not get translated into expectations of higher inflation down the road and thus do not lead to a general increase in prices, today or tomorrow. In light of the evidence, the Fed is right to pay more attention to core inflation than to overall inflation when making decisions about interest rates.

His point is true if you look at the evidence. But this is due in large part to the instability of food and energy prices. If they increase dramatically, they often decrease shortly thereafter. This is because temporary economic shocks often cause these price swings. A winter chill in central Florida kills the orange crops; flooding in the Midwest ruins thousands of acres of wheat; a war in the Middle East pushes up gasoline prices. The list goes on. When these price changes are fleeting, they have little impact on long-term inflation.

This applies fairly well to the recent oil price spikes we've seen associated with the unrest in the Middle East. With energy, demand can rise and fall considerably depending on how the economy is doing, while supply can rise and fall on the stability of oil-rich regions of the world. Unless a supply or demand shock for energy is permanent, it won't impact long-term inflation trends.

But what happens when the price changes are permanent? As Meyer says, one of the major reasons why food prices are rising is due to fast-growing Asian economies. That isn't likely to be a temporary shock. These nations aren't expected to shrink -- they're going to keep growing at a brisk pace as they continue to develop. Food is a consumer staple, so any temporary changes its prices experience are more likely based on a supply shock.

So assuming a permanent demand shift is one of the chief reasons for rising food prices, this component of inflation rising doesn't appear to be a temporary fluctuation that economists can just cast aside. Instead, rising food prices look permanent.

This complicates the inflation expectation calculus. Although core price level is generally a good measure to use when predicting future inflation, food and energy prices do sometimes undergo fundamental long-term shifts in supply or demand that will impact long-term prices. When these permanent swings are large, basing monetary policy on core inflation alone won't be as effective.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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