Looking Hard at InflationAll of It

The Fed has long made policy while averting its eyes from food and energy. But it may be impossible to turn away any longer

The Federal Reserve's past emphasis on core inflation, which strips food and energy from the price indexes in order to gauge the underlying trend of prices, has always confused both Wall Street and Main Street. How can the Fed make monetary policy while ignoring two items that make up 23% of the consumer price index? As the old complaint goes: Core inflation makes sense only for people who don't eat or drive. Now, as part of a communications overhaul, Fed policymakers are finally giving total inflation its due. Beginning with the minutes of the Oct. 30-31 policy meetings, released on Nov. 20, the Fed is offering the public its forecasts of both total and core inflation instead of only the latter.

The change is part of the central bank's new transparency effort "to improve the accountability and public understanding of U.S. monetary policy." The Fed will publish its economic projections for growth, inflation, and unemployment four times a year instead of two. It will extend its forecast horizon to three years, from two. It also will offer a "narrative" to explain the consensus judgment, as well as differences among the policymakers.

The new attention to total inflation comes at a tricky time for the Fed. In the coming months, while growing evidence of a weak economy is likely to bolster arguments for further interest-rate cuts, overall inflation is expected to speed up to a pace far greater than the core rate. Except for the period after Hurricane Katrina in 2005, the gap could be the widest since 1980. The Fed often has expressed concern that costlier energy and food have the potential to lift other prices. Indeed, over long periods, total and core inflation have moved roughly together.

The upward push from energy and food was evident in the October consumer price index. The total CPI jumped 3.5% from a year ago, up from September's 2.8% clip, while the core rate edged up to 2.2%, from 2.1%. The November CPI is expected to rise about 4%, powered by gasoline and other fuels. Food inflation, at 4.4% in October, has doubled since the end of 2006 and is the highest in 16 years.

Based on the Fed's preferred measure, the price index for personal consumption expenditures, most policymakers expect overall inflation to end 2007 between 2.9% and 3%, with core prices rising 1.8% to 1.9%. In the long run, given "appropriate" policy, the Fed foresees total and core inflation converging to between 1.6% and 1.9% by 2010. Policymakers hope these outer-year projections will be seen by investors as a target for price stability that will guide policy and anchor inflation expectations. If people expect low inflation over the long haul, they won't let transitory jumps in energy and food alter their pricing, buying, and wage-setting behavior.

Still, the Fed must make policy decisions in the short run, and the crosswinds building up for its Dec. 11 meeting are the stiffest in years. In addition to the uncomfortable level of overall inflation, reports show the economy is slowing sharply. In the three months through October, retail sales outside of autos, gasoline, and building materials have fallen for the first time in five years, and manufacturing output is declining. Despite strong exports, domestic demand is too weak to support production gains.

Also, a growing number of influences on inflation are beyond the Fed's control. In recent years, policymakers have expected oil prices to moderate, yet strong global growth has pushed them higher. The dollar's plunge is another factor. Higher food prices partly reflect the shift to ethanol production, but prices of imported foods and feeds are up nearly 10% over the past year, and prices of Chinese imports are accelerating. Also, productivity has slowed and is not providing the same inflation cushion as earlier in the decade.

Current tame readings on core inflation may no longer offer the same comfort to policymakers they once did. The growing pressure on total inflation is a new risk that could rob the Fed of some maneuvering room.

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