Oil, Inflation, and Monetary Policy

Monetary policy is one of the basic mechanisms through which rising oil prices are believed to hurt the economy: oil prices rise, inflation results, central bankers raise rates, and the economy slows. Over the last decade or two, though, most economists – at least in the United States – have come to believe that policymakers should focus on core inflation, which ignores energy and food prices, rather than headline inflation, which includes them. To the extent that Fed officials focus on core inflation, oil prices rises don’t necessarily spur inflation; consequently, officials don’t raise rates, and the economy doesn’t suffer.

That view is less popular in Europe. Lorenzo Bini Smaghi, a member of the executive board of the European Central Bank, presents the counterargument well in a Financial Times op-ed today:

“The rationale for excluding food and energy, however, is that they tend to fluctuate sharply, as we have seen with recent rises and falls in the price of oil. This volatility is then passed on into the general price index, in turn making it difficult to interpret the overall trend…. However, for core inflation to be a good basis for forecasting headline inflation, the variations in the prices of agricultural and energy products have to be temporary, and should on average not differ from other prices. If that is not the case, core inflation is neither a good estimate of underlying inflation, nor a good forecast of future inflation…. Since 1999, the global index of energy and raw materials prices has more than doubled, as has that of food prices. These increases have not been short-lived at all, but have had a lasting effect.”

This argument makes sense as far as it goes. The original rationale for focusing on core inflation – that it allowed policymakers to filter out volatility, and hence avoid rash rate rises – is pretty difficult to defend at this point. Structural changes in world energy (and food) markets mean that price rises in those areas are much more likely to be permanent than they once were; hence, to the extent that they ignore them, policymakers are being willfully blind to real stresses being faced by consumers and firms.

But Bini Smaghi and his intellectual bedfellows take things a step too far. Here’s how he concludes:

“For central banks around the world, this means that core inflation is no longer a very useful indicator for monetary policy, and should probably be abandoned.”

What this means, in practical terms, is that he thinks policymakers should focus on headline inflation instead. That, in turn, means that high headline inflation should prompt central banks to raise interest rates. This strikes me as missing the big picture.

Why? Central bankers should respond to inflation because (a) they believe that inflation will be highly damaging, and (b) they believe that their policy can blunt the damages. Inflation is particularly dangerous when it drives demands for higher wages, which in turn fuels more inflation, and so on. But this is not a significant risk in Europe or the United States right now: with unemployment still through the roof, workers don’t have much leverage to extract wage increases. Indeed in much of the periphery of Europe, real wage declines (through modest inflation) may be just what’s needed.

But let’s accept, for now, that current levels of inflation are too high. It’s still not clear that ECB rate-raising can do much about them. Since the ECB doesn’t need to move in order to keep wages in check, it would have to have its impact by reducing inflation directly, i.e. by reducing demand for energy and food (or for other goods and services, in order to compensate). But as Bini Smaghi writes in his column, “a structural change has taken place over the past decade, in which strong growth in emerging countries has increased global demand for raw materials in an unprecedented way.” So higher ECB rates would need choke off demand in a compensating fashion. This seems draconian: the ECB would basically need to blunt growth in an already struggling eurozone – not as an unfortunate side effect of its policy but as its main objective. The cure would be worse than the disease.

There is one potential counterargument to this: perhaps loose monetary policy is the root cause of high commodity prices in the first place. If that was the case, then there might be a legitimate argument for blunting inflation through tighter monetary policy. But that line of argument is totally inconsistent with the one that Bini Smaghi and similar inflation hawks offer. They are arguing that core inflation should be ditched because energy and food price rises substantially reflect enduring fundamentals (which I think is a correct assessment of the facts). That’s the opposite of an argument that they’re a consequence of loose monetary policy.

This leaves us in a rather confusing place. The critics of core inflation are right to argue that it no longer deserves to occupy the central place that it did in the 1980s and 1990s. But those who thus counsel a return to simply targeting nominal inflation are wrong, not only for the reasons outlined above, but because while there have been (and continue to be) big structural changes in energy and food markets, those markets also remain quite volatile (indeed at least energy markets have become more volatile than before). Core inflation, by filtering out this volatility, can thus provide some useful information. Perhaps some smart economists will come up with a new magic number that can replace both of these and anchor monetary policymaking in this new era. Until then, though, policymakers will need to muddle through, looking holistically at the economy rather than simply fixating on one number. There are, of course, bound to be mistakes that result. This is simply another element of the economic risk involved in a navigating the rapidly changing global economy.