So-called 'headline inflation,' boosted by outsize increases in energy and food prices, is clearly too rapid for comfort.

Core measures of inflation, which abstract from fluctuations in prices of food and energy, have been better-behaved, perhaps because real incomes and spending have been restrained by the run-up in food and energy costs.

As reported by Market News International

To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.

The rise in commodity prices presents particular challenges for monetary policy because such increases both add to near-term inflationary pressures and damp demand. A tendency for increases in commodity prices to become a factor in ongoing pricing and wage-setting more generally would be a worrisome development that would over time tend to undermine economic welfare.

Inflation was disappointing as well last year. The price index for personal consumption expenditures rose by 3.6 percent during 2007, compared to 2.3 percent the year before. Rapid increases in food and energy prices were the obvious culprits, but that provides little comfort to this central banker. The Federal Reserve is responsible for keeping total inflation low and stable—including food and energy prices. While the effects of unexpected commodity price increases are difficult to offset rapidly, an appropriate monetary policy would ensure that such shocks even out over time and do not impart a persistent inflation bias—either up or down.

Energy has systematically begun to increase at a faster rate, food is systematically increasing, therefore the rationale for taking it out of the total (consumer price index) and looking at the core is less compelling. And so I am looking, and I think others are, at the total CPI, or (personal consumption expenditures) number as much as, if not more, now, than the core.

From Q&A as reported by Reuters

There is no evidence that is occurring, "but that's a danger," she said, noting that inflation is due to negative supply shocks to the economy, not the result of "everyone drinking the punch."

...

She said she continues to view core CPI as a better "forward-looking" measure of inflation, but only if one believes, as futures markets are predicting, that food and energy prices will eventually stabilize. And on that score futures markets in recent years have been "wrong, wrong and wrong." However, policymakers cannot claim to have achieved price stability "unless it shows up in the headline number," she said.

From Q&A as reported by Market News International

The thirst of the emerging-market economies for raw materials and the relative inefficiency with which they use these raw materials has propelled industrial commodity prices to record levels. The fact that these increases have been persistent and not quickly reversed has raised tough questions about traditional measures of core inflation and made it increasingly difficult for central bankers to separate signal from noise in the inflation data.

We see it in particularly in commodities, and energy products. Those are usually taken out in core inflation measurements. However in Dallas, at the Dallas Fed, we don't use a core measurement. We use a trimmed mean measurement and even on that basis we see inflationary levels rising.

The basic point from these simulations is that monetary policy that responds to headline inflation rather than to core inflation in response to an oil price shock pushes unemployment markedly higher than monetary policy that responds to core inflation. In addition, because this policy has larger swings in the federal funds rate that must be reversed, it leads to more pronounced swings in unemployment. On the other hand, monetary policy that responds to core inflation does not lead to appreciably worse performance on stabilizing inflation than does monetary policy that responds to headline inflation. Stabilizing core inflation, therefore, leads to better economic outcomes than stabilizing headline inflation.

Could it be that there are now trends in place in the relative prices of food and energy? I am not prepared to dismiss this possibility. Rapid economic development in China and India has placed increased demand on the world capacity to produce both food and energy and therefore has surely contributed to the persistent gap between core and headline inflation numbers observed over the past five years. It is not unreasonable to forecast that increased demand for food and energy by emerging economies with large populations will continue for a considerable period. This possibility suggests the FOMC must exercise caution lest monetary policy inadvertently accommodate an increased inflation trend by focusing on the behavior of price indexes excluding food and energy.

Although the danger is real, it is also true that oil futures prices for contracts several years ahead do not suggest continuing increases in oil prices of the magnitude observed over the past five years. That was also true five years ago—the futures market turned out to be wrong. However, my view is that policymakers should rely on the judgment of the markets unless we have solid evidence that the markets are wrong. My personal experience is that, although the markets obviously can be wrong, I have no confidence that my own judgment on something like oil prices will be systematically more accurate.

I think there's a lot of inertia to (core) inflation. It's hard to get it to decelerate or
accelerate, ... My own view is core inflation will diminish over the next several years.

From press Q&A as reported by Market News International

Although most of the recent concern about the U.S. economy has been focused on growth, we must also be mindful of inflationary pressures. The recent news here has been somewhat disappointing. We have experienced large increases in food and energy prices, and other commodity prices are high; in addition, we are hearing numerous anecdotes of firms passing on cost increases to their downstream customers... [I]f outsized increases in food and energy prices persist, then core becomes a less useful medium-term guide to inflation trends. Furthermore, persistent food and energy price increases will find their way into inflation expectations, which in turn would boost core measures. So the recent developments in food and energy prices are a concern that deserve careful monitoring. That said, our forecast is for inflation to moderate over the next two years.

I have to say that I am uncomfortable with the inflation picture, and disappointed that the improvement we saw earlier this year was not more lasting.

I am also troubled by the lengthy divergence we've seen between overall and core inflation. Some of you may recall that core inflation was devised in the 1970s to filter out some of the more volatile consumer prices to get a better read on inflation trends. For several decades, core inflation seemed to work well due to the fact that food and energy prices had no clear trend relative to the overall price level. In the last few years, though, overall inflation has been persistently above core inflation, and few observers expect oil prices to go back below $20 per barrel. Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation. Going forward, markets expect oil prices to back off slightly from their current level, and I hope they are right this time.

Since August, however, the inflation picture has deteriorated. In September and October, the overall PCE price index rose at a 3.3 percent annual rate, and the core index rose at a 2.6 percent rate. Judging by the closely related consumer price index, the numbers for November will be even worse. Now these numbers do display transitory swings, so I wouldn't extrapolate them forward indefinitely. Still, I have to say that I am uncomfortable with the inflation picture, and disappointed that the improvement we saw earlier this year was not more lasting.

I am also troubled by the lengthy divergence we've seen between overall and core inflation. Some of you may recall that core inflation was devised in the 1970s to filter out some of the more volatile consumer prices to get a better read on inflation trends. For several decades, core inflation seemed to work well due to the fact that food and energy prices had no clear trend relative to the overall price level. In the last few years, though, overall inflation has been persistently above core inflation, and few observers expect oil prices to go back below $20 per barrel. Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation. Going forward, markets expect oil prices to back off slightly from their current level, and I hope they are right. If energy prices fail to decline, monetary policy decisions will be that much more difficult in 2008.

In addition to growth, I'm keeping a close watch on prices. Readings on inflation have improved this year, and I believe that inflation will most likely continue to moderate as measured by so-called core inflation indices. But there are some inflationary risks. In particular, recent increases in energy and commodity prices, among other factors, could put renewed upward pressure on headline inflationthe inflation you and I encounter in the marketplace.