History Backs Bernanke Betting Volatility Variable Won’t Hurt

Federal Reserve Chairman Ben S. Bernanke
Ben S. Bernanke, chairman of the U.S. Federal Reserve. Photographer: Andrew Harrer/Bloomberg

Federal Reserve Chairman Ben S. Bernanke is betting that surging prices for food and fuel won’t wind up breaking the cost of living for Americans. The historical record shows the odds are in his favor.

The Fed watches two key measures of inflation, known to economists as headline and core. The first is based on a basket of goods and services bought by the average American consumer. The second strips out volatile food and energy prices, providing a better picture of long-term trends.

While both have averaged about 2 percent a year since 1996, based on the personal-consumption expenditures index, headline inflation has jumped as high as 4.5 percent and fallen to minus 1 percent. In the same period, changes in core prices ranged from increases of 0.7 percent to 2.6 percent.

“From an economist’s perspective, it’s right to focus on the core,” said Vincent Reinhart, a former Fed official who is now a resident scholar at the American Enterprise Institute in Washington. “Appropriately, the Fed’s goal is headline inflation, but it’s headline inflation in the future, and therefore core is the good predictor.”

The rate of “pass-through from commodity-price increases to broad indexes of U.S. consumer prices has been quite low in recent decades,” Bernanke, a 57-year-old former Princeton University professor, said March 1 in his semiannual monetary-policy testimony to Congress. That points to a “temporary and relatively modest increase in U.S. consumer-price inflation,” he said.

Testing an Assumption

Surging prices of oil, corn and other commodities are testing that assumption. Crude oil has jumped 35 percent in the past six months, corn is up 38 percent and cotton is up 89 percent.

“If you talk to an average family in New Jersey and you say, ‘What is your food bill? What is your gas price? What is your tuition?’” they are “not going to tell you there’s deflation,” said Senator Robert Menendez, a New Jersey Democrat, when he questioned Bernanke after his testimony. “In a real context, I’m wondering how this macroeconomic policy is going to get to the average person in a way that changes their lives in a more positive way.”

A gallon of gasoline averaged $3.587 on March 28, the highest since October 2008, according to Heathrow, Florida-based AAA, the nation’s largest motoring organization. The increase helped push consumer confidence to the lowest level since August, as the Bloomberg Consumer Comfort Index dropped to minus 48.9 in the week to March 20.

Rise and Fall

David Resler, chief U.S. economist at Nomura Securities International Inc. in New York, says prices of commodities can fall just as quickly as they rise. Corn jumped 21 percent from the start of the year to March 3 before dropping 8 percent. Oil fell 8 percent between Jan. 1 and Feb. 15, then rose 25 percent by March 7. Since then, it has declined about 1 percent.

Bernanke is “saying the rate of change is temporary or transitory, and he’s almost certainly right,” said Resler, the second most-accurate forecaster of the inflation rate in the past two years, according to Bloomberg News calculations. Oil may “move sharply lower” once the crisis in the Middle East passes, he said. “It’s hard to envision prices continuing to rise at these rates.”

Rapid moves in oil were even more pronounced in 2008, when the price of a barrel reached $145 in July because of possible supply constraints from Middle East conflicts and production disputes in Russia. The price dropped to $34 a barrel in December as tensions eased.

Extremely Rapidly

If the Fed had focused strictly on headline inflation, which rose to 4.5 percent in July 2008, it likely would have raised rates in the midst of the recession that began December 2007 and then had to drop them extremely rapidly as overall prices turned negative, according to Paul Ashworth, chief U.S. economist at Capital Economics Ltd. in Toronto. Instead it continued cuts it began in September 2007, when the federal funds target rate was 5.25 percent, eventually slashing its benchmark to near zero by December 2008.

“You can make errors,” Ashworth said. “In 2008 if you’d followed strictly headline, then you’d look like idiots when headline inflation was actually below zero in 2009.”

The bond market agrees with Bernanke’s assessment. Investors anticipate inflation of 2.7 percent in the next 12 months, as measured by the difference between yields on nominal bonds and Treasury Inflation Protected Securities. That reflects their expectation that the current surge in commodities is temporary and modest; in the next five years, investors estimate inflation will average 2.3 percent annually.

Even though the budget deficit has grown, the cost of financing it is now lower than it was before the credit crisis began in August 2007.

Slack in Economy

Bernanke has said the level of slack in the economy makes it difficult for companies to raise prices, as 14.5 million workers remain unemployed. The manufacturing, mining and electric-and-gas-utilities industries also are using only 77 percent of their capacity, according to Fed data. While core prices rose 0.9 percent in February from a year earlier, the most since October, they remain near record lows.

Bernanke and the Federal Open Market Committee said March 15 they will continue to keep interest rates near zero and maintain record monetary stimulus with purchases of $600 billion in Treasury securities through June. Rising commodity prices will prove “transitory” and “measures of underlying inflation have been subdued,” the FOMC said.

Trichet Surprise

The Fed’s approach sets it apart from the European Central Bank and Bank of England. ECB President Jean-Claude Trichet surprised investors earlier this month when he announced the central bank may raise its benchmark rate in April from a record low 1 percent. In the United Kingdom, a 4.4 percent consumer-price increase in February from a year earlier is pressuring policy makers to consider raising England’s target rate above its record low of 0.5 percent.

“The implication is that, unless U.S. underlying inflation begins to rise, the Fed will continue to lag behind the ECB and the BOE, both of which are much more sensitive to the impact from commodities-driven headline CPI rates on inflation expectations,” said Lena Komileva, the global head of G-10 strategy in London for Brown Brothers Harriman & Co.

Maury Harris, chief U.S. economist in New York at UBS Securities LLC, says Bernanke may be falling behind the curve.

“There ought to be some questions about whether the Fed is on the right track when they say core inflation will be contained,” he said. His team at UBS Securities, the best inflation forecasters for the past two years according to Bloomberg calculations, see prices excluding food and energy rising 1.4 percent this year, compared with the median forecast of 1.1 percent in a Bloomberg survey.

‘Totally Implausible’

The Fed’s credibility also is at risk, Harris said. Ordinary people “find it totally implausible that somebody from the Fed would play down inflation,” he said.

Inflation expectations among U.S. consumers for the year ahead jumped to 4.6 percent this month from 3.4 percent in February, according to a Thomson Reuters/University of Michigan survey. Expectations for five years from now rose to 3.2 percent from 2.9 percent.

Reinhart agrees that concepts like core inflation have little meaning for consumers watching the price of gasoline and groceries rise from one week to the next.

“When you talk about core, you disconnect yourself from the public who think ‘What, you don’t drive or eat?’” he said. Even so, Bernanke is right when he says “the pass-through has been essentially non-existent” for the last several decades, Reinhart said.

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