Hard core

By Megan McArdle

Daniel Gross adds his voice to the chorus of people complaining that "core inflation"--inflation excluding food and energy prices--is a silly measure. They're mad because this silly measure is the one the Fed pays most attention to.

And the Fed is right. The reason the Fed watches inflation is to try to determine if the money supply is in excess of money demand. If it is, there will be too much money chasing too few goods, and prices will start to rise.

But those price increases will be broad, general price increases, led by demand. The problem is, food and energy prices are generally most affected not by fluctuations in demand, but by fluctuations in supply--or in the expectation of future supplies.

Gross compares American inflation to China, where food inflation is rampant. But in China, most people still don't have enough to eat by rich-world standards. That means that when they get a little extra money, they will often bid up the prices of food commodities, particularly expensive ones such as pork. Until supply increases to match increased demand, this will result in skyrocketing, demand side prices.

In America, however, food is a trivial part of almost everyone's budget. People who get a little extra money in their pocket don't spend it on putting more protein in their diet: they buy a nicer washer, an iPod, a nice trip to the Jersey Shore. Price fluctuations are driven by the size of the harvests here and abroad. Similarly, the change in the price of oil has not been caused by a sharp shift in American demand, but by increasing demand elsewhere running up against a limited supply.

In other words, though it may hit your wallet hard, these two kinds of inflation don't tell us much about the state of the money supply--whether it is too big, too small, or just right. They just tell us that the domestic market for these goods has experienced some kind of negative supply shock. And that's not in the Federal Reserve's power to correct.

This article available online at:

http://www.theatlantic.com/business/archive/2007/10/hard-core/2035/