Right now, we are trying to understand the dynamics of inflation The headline personal consumption expenditures (PCE) price index fell 0.2 percent in December. Its 12-month increase was 0.75 percent, down from 1.6 percent in June. Should this low, and still falling, rate of price inflation retard the date of the liftoff from the zero-interest-rate policy we have been operating for more than six years?

I think not. We all know that headline inflation is being held down by the big decline in energy prices that began in the second half of 2014. We know that once energy prices stabilize, headline inflation is likely to bounce right back up. Policy needs to take past inflation into account, but it needs to take future inflation into account, too. Thats just another way of saying that, for policy purposes, its inflations medium-term trend that matterswhich is why analysts and policymakers pay so much attention to core inflation measures. The widely heralded FRB/US model that has been used by the Board of Governors staff since 1996 is an example: It is built around PCE inflation excluding food and energywhich is the traditional measure of core inflation. Ex-food-and-energy PCE inflation was essentially zero in December, month over month, while the 12-month rate slipped to 1.3 percent from 1.5 percent in June.
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A good core inflation measure strips the noise out of headline inflation and leaves the signal. By that standard, recent analysis shows that the ex-food-and-energy PCE inflation rate that drives the FRB/US inflation forecast is a second-rate core inflation measure, at best. An alternative measure developed at the Dallas Fedthe Trimmed Mean PCEis superior in three respects.

First, trimmed mean inflation is better insulated from transitory energy-price swings. Since 1994 (the start of the current 2 percent-inflation era), conventional core inflations correlation with changes in the real price of oil is 0.26, while trimmed mean inflations correlation is just 0.05.

Second, as judged by root-mean-square error, it is more closely aligned with intuitive, direct measures of trend headline inflationlike the 36-month centered average, or headline inflations average over the coming 24-month periodthat we are only able to observe after the fact.

Third, trimmed mean inflation has shown substantially less systematic bias. Over the past 10 years, looking only at data that would have been available to policymakers in real time, conventional core PCE inflation has averaged 1.65 percentnearly 30 basis points below headline inflations 1.94 percent average. Meanwhile, trimmed mean inflation has come in at 1.83 percentjust 10 basis points below headline. Setting policy using conventional core as your guide is like navigating using a compass: It has a systematic bias and is influenced by local anomalies in the Earths magnetic field. Using the trimmed mean to set policy is more akin to navigating by GPS.

I wrote that the cores were out and we should start focusing  more on headline inflation. You can check it out on my web page and what (ph) a recent speech I gave. But I've argued pretty strenuously that it's inappropriate to be throwing out food and energy prices. And especially in this environment where those are the prices that are going up the most. Those are the key shopping experiences for many households. It really hurts Fed credibility to be ignoring those prices when we're talking about inflation. So I'm very much in favor of looking at the headline number. I would smooth it out a little bit by looking at it over the last year or something, but - but I'm perfectly happy to look at the headline number.

“Headline inflation is the ultimate objective of monetary policy with respect to prices,” Bullard said, noting that these are the prices that households actually pay.  “Core is not an objective in itself,” he added.  He said that while the only reason to look at core is as an intermediate target for headline, “its use as an intermediate target is questionable.”

It is time to drop the emphasis on core inflation as a meaningful way to interpret the inflation process in the U.S.

One immediate benefit of dropping the emphasis on core inflation would be to reconnect the Fed with households and businesses who know price changes when they see them.

“Headline inflation is the ultimate objective of monetary policy with respect to prices,” Bullard said, noting that these are the prices that households actually pay. “Core inflation is not an objective in itself,” he added. “The only reason to look at core is as an indicator for headline.”

“Headline inflation is the ultimate objective of monetary policy with respect to prices,” Bullard said, noting that these are the prices households actually pay. “Core inflation is not an objective in itself,” he added. “The only reason to look at core is as an indicator for headline.”

Tarullo said looking at so-called core inflation, which strips out volatile food and energy items and remains below the Fed's informal 2.0% target, is better to set monetary policy, which acts with a lag.   "In the U.S. context ... it's proven a more appropriate metric since there's a better correlation between core inflation today and inflation tomorrow," Tarullo said.

As reported by Dow Jones

Federal Reserve Governor Daniel Tarullo said he sees no need to either terminate the central bank’s program of large-scale asset purchases before it’s scheduled to end in June or to increase its size.

As reported by Bloomberg News

In my view, it is more important that central banks focus on some measure of inflation in conducting monetary policy and less important whether that measure is headline inflation or core inflation. Over time, the trends in headline inflation and core inflation in most countries tend to move together. Also, an average inflation rate over a two- or three-year period will be less subject to food price volatility than an average over a one-year period. Consequently, policymakers could choose either inflation measure in setting a medium-term policy goal. For me, the key issue is that central banks seek to achieve a relatively stable price level, rather than the measure they choose.

Research by my staff shows that while the SPF forecasts were sensitive to headline inflation data in the past, these forecasts have responded in recent years to core rather than headline inflation data.4 This finding suggests that professional forecasters no longer expect relative price changes to have a persistent effect on inflation.

It seems to me that a change in the conduct of monetary policy following the experience of the 1970s has probably caused inflation expectations to become better anchored, explaining why recent oil shocks have inflicted relatively little damage on the economy. This hypothesis could at least partly explain why the huge run-up in energy prices through the middle of last year was not accompanied by rising wage demands. That in turn enabled the Fed to follow an easier monetary policy that gave greater weight to the output effect of rising oil prices than would have otherwise been possible.

Since mid-2008, oil prices have, of course, plummeted. But the extraordinary weakness in the economy means that the usual trade-offs associated with such supply shocks are absent right now. Any boost to spending from falling oil prices will be more than welcome in the current circumstances. And with inflation now below desirable levels, a decline in inflationary expectations that could push core inflation down over time would be most unwelcome. I argued earlier that the Fed’s inflation credibility helped over a number of years to keep inflationary expectations anchored in the face of rising oil prices and high headline inflation. My hope is that inflationary expectations will remain similarly well-anchored now, serving to stabilize core inflation. The FOMC’s recently released longer-run inflation projections should be useful in this regard, helping to reinforce inflation expectations of around 2 percent.

In my view, the compositional differences {between the CPI and PCE price index} don't clearly favor one index versus the other. While the level of the inflation rate measured by the two indices differs at any point in time, over the short term both generally give the same signal about the pattern of inflation.

Taken together, measures of both CPI and PCE inflation are important tools to help get a fix on the overall inflation picture, giving us a sense of whether the inflation is persistent or transitory along with other information needed to make informed policy decisions.
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I agree with those who say core inflation measures in isolation are an inadequate approach to determining the direction of overall price changes. Like you, I ultimately care about the trend rate of overall inflation, which I believe is ultimately the appropriate object of monetary policy.

For the moment, higher headline rates of inflation have shown only a few tentative signs of embedding themselves in core inflation or in longer-term inflation expectations. However, policymakers around the world must monitor the situation carefully for signs that the increases in relative prices globally do not generate persistently higher inflation. Additionally, in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability.

My sense is that actual headline inflation in excess of 3.0 percent coupled with inflation expectations near 2.5 percent will not be compatible for long. If inflation remains elevated, inflation expectations will begin to move higher. Market participants, businesses, and consumers will come to view higher inflation as part of the economic landscape, in part because of doubts about the Fed’s ability and willingness to keep inflation contained. These expectations, if allowed to persist, will then feed into the equilibrium of the economy and will be difficult to reverse. In short, credibility is much easier to keep than it is to recover.

Should policymakers take into consideration persistent differences in headline and core measures of inflation? ...Let me stress that I do not have an answer to this question, but I think it has become an important concern for the FOMC. Again, what is new here is relative price trends in food and energy that may plausibly be expected to persist for some time. If it were just a matter of the food and energy components being volatile, I think a theoretical case could be made that these prices contain too much noise and so should be ignored in day-to-day policy decisions. Historically, the ex-food and energy calculation seems to have worked well, even though arbitrarily ignoring certain prices is not very elegant. With relative price trends, the ad hoc approach to this question is becoming increasingly untenable.

In the long run, in my view, it is total inflation – rather than core inflation, which excludes the volatile food and energy components – that should be the focus of monetary policy.