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.