The Regional Economist • January 2002

Inflation:Ijrooo .Ijror iJnouani

By William T. Gavin and Rachel J. Mandal

"When I was your age, I walked 20 miles uphillin the snow to get to school and a gallon of milkonly cost a nickel/7 Who doesn't remember grand-parents and relatives sharing similar stories withus at family get-togethers? Today, a gallon of milkat the grocery store will cost more than a nickel,as will other goods that our grandparents paidconsiderably less for in their day. The overall risein prices is known to economists as inflation.

Over the long run, inflation is caused by toomuch growth in the money supply. Monetaryinflation is bad because it obscures the price signalsthat make our market system work efficiently Thejob of monetary policy is to supply just the rightamount of money so that the average price levelremains stable.

Over short periods, however, inflation can be influ-enced by large changes in the market for particulargoods and services. Because these bouts of inflation

[5]

tend to be short-lived and self-correct-ing, the proper monetary policy responseis to ignore them. The problem forthe Federal Reserve is to know wheninflation is due to excessive monetarygrowth (requiring a policy response)and when it is due to transitory market

Approximately 25 percent of theitems in the PCEPI basket are excludedfrom the CPI basket. A guiding princi-ple for deciding whether an itembelongs in the CPI basket is whether itis paid for "out of pocket." The mainitems in the PCEPI that are not includ-

Just as noise filters are used to remove the static inradio signals, economists filter inflation data to remove

the static caused by supply and demand changes.

fluctuations. To sort out the short-runreal effects caused by disruptions toparticular markets from the long-runmonetary effects caused by FederalReserve policy, economists have devel-oped techniques to filter the inflationnews. Traditionally, economists haveexcluded food and energy prices intheir filtering process, but we find thatby filtering out food prices, we mightbe losing valuable informationabout inflation.

ed in the CPI are things that con-sumers get but don't pay for out ofpocket, such as free checking, employ-er-funded medical care and medicalservices paid through Medicare andMedicaid. Also, the CPI is an indexof inflation for urban dwellers; so, itexcludes spending by rural households.

The PCEPI, then, is a larger andbroader index that includes a more var-ied bundle of goods than the CPI does.

Although both are validfor gauging infla-

tion, in 2000the Federal

Reservebegan

Consistently volatile componentsof the PCEPI obscure economists'ability to evaluate monetary policyand the true inflation trend. To geta better idea of the underlyinginflation trend, economists look atcore inflation, which is traditionallymeasured by the PCEPI excludingfood and energy. Removing foodand energy from the PCEPI resultsin a less volatile series and a bet-ter gauge of the underlying infla-tion trend.

What's in the Basket?

Economists looking at inflationgenerally track a price index, whichis the average price of a consistent"basket" of consumer goods. Thetwo major price indexes are theConsumer Price Index (CPI) and thePersonal Consumption ExpendituresPrice Index (PCEPI).

The CPI, reported by the Bureauof Labor Statistics, was created for thespecific purpose of adjusting veterans'pension benefits for inflation follow-ing WWI, while the PCEPI, reportedby the Bureau of Economic Analysis,is used to compute the nation's GrossDomestic Product. Both indexesmeasure the rate of inflation facedby consumers, but the PCEPI ismore comprehensive.

reportingits inflation forecasts

in terms of the PCEPI instead of theCPI. Because of the PCEPI's wider bas-ket of goods and the Fed's focus on it,we'll look only at the PCEPI, althoughour conclusions also apply to the CPI.1

When tracking inflation, peoplemonitor data releases to predict theunderlying inflation trend, which isdriven solely by monetary policy.However, information about the infla-tion trend has been compared to aradio signal that is obscured by static.Just as noise filters are used to removethe static in radio signals, economistsfilter inflation data to remove the staticcaused by supply and demand changes.One way to filter the inflation news isto measure the change in prices over along period, such as a year, to eliminatethe short-run fluctuations. But then, theuseful information is delayed for a year.

[6]

r(Quarterly Data,Percent Change atan Annual Rate)

Inflation in PCEPIvs. PCEPI excludingFood and Energy

The Regional Economist • January 2002

wvuvu.stls.frb.org

Another way that economists filterout the static is to delete the items inthe price index that are sensitive tolarge, frequent disturbances to supplyand demand and, therefore, havehighly volatile prices. After deletingthese items, what is left is core inflation,that is, inflation in the basket of goodsexcluding the more volatile compo-nents. Since the 1970s, core inflationhas typically been measured by exclud-ing food and energy from the basket

of goods. This is because theearly 1970s saw

much more than the food componentor the all-item PCEPI. We also see thatfood prices have become increasinglystable recently, while energy pricescontinue to fluctuate significantly.

What has caused the recent increasein the stability of food prices? Improve-ments in technology and a change inconsumer eating habits have both con-tributed.2 Major advancements in thefood distribution system have led toshorter lag times between picking pro-duce at the farm and getting it into thehands of urban consumers. It is not

unusual, as it once was,

(Quarterly Data, PercentChange at an Annual Rate)

highly volatile food prices and, soonafterward, a rapid rise in the prices ofgas, oil and other energy products.

The core measure of inflation, thePCEPI excluding food and energy, hasbeen less sensitive to temporary shocksto the economy and has seemed tohave been a better barometer of theunderlying trend in inflation than theall-item PCEPI. Looking at Figure 1,we see that the rate of inflation meas-ured by the PCEPI excluding food andenergy has been less volatile than withthe all-item index. During times ofhigh inflation, such as the mid-1970sand early 1980s, the PCEPI excludingfood and energy did not increase nearlyas much as the all-item PCEPI. Wheninflation dropped considerably in themiddle of 1986, the index excludingfood and energy did not show thesame massive drop.

Let's take a closer look at thechanges in the prices of componentsexcluded from the core: food and ener-gy. From Figure 2, we see that inflationin energy prices indeed has been veryvolatile, increasing and decreasing

for a shopper in a supermarket inChicago to be buying fresh producegrown in South America. As techno-logical advances have reduced the costof air freight and refrigeration, their usehas become widespread and common-place in the food industry, increasingthe geographic size of the market forfood and reducing the volatility offood prices.

Another change in the food distribu-tion system is that many more peoplenow buy their food from large grocerystore chains. These large chains havean advantage over smaller specialtyretailers in that they have the ability tostock larger quantities of many moredifferent types of items. Large super-markets purchase food directly fromthe producers in huge quantities,cutting the cost to themselves andtheir consumers.

Eating habits of the American con-sumer also have changed. With thehectic schedule many Americans have,people are less inclined to buy freshfruit, vegetables, meat and poultry thatmay go bad in their refrigerators or

Typical measures of core PCEPIinflation have excluded foodand energy prices because oftheir volatility. However, due toadvances in food distribution tech-nology and changes in consumereating habits, food prices have sta-bilized recently, while energy pricescontinue to fluctuate dramatically.By continuing to exclude food fromcore inflation, we might be losinginformation about the underlyinginflation trend.

[7]

Inflation inFood Prices vs.Energy Prices

^ ®ffi®

require time and energy to prepare.People are much more likely to buyprepared meals at the grocery store or

to eat at restaurants. The pricesthat consumers pay for these

of the trend, or equivalently, a betterforecast of future inflation. The ques-tion here is whether food is like ener-gy. We find that it is not. Not only isthe food component of the PCEPI one

of the least volatile

The PCEPI excluding food andenergy is typically used as an indi-cator of the underlying inflationtrend, and a good indicator of theunderlying trend should also be agood predictor of future inflation.Using past inflation in the priceof food and the PCEPI excludingfood and energy as a prediction foroverall inflation in the next twoyears, we see that past food priceshave been a better forecast offuture overall inflation than thePCEPI excluding food and energy.The forecast errors (predictedinflation minus actual inflation) forfood prices are smaller than thosefor the PCEPI excluding food andenergy, and the PCEPI excludingfood and energy was more oftenabove actual inflation than below(as seen by the preponderance ofpoints above the zero line), mean-ing that it had a tendency to pre-dict a higher rate of inflation thanactually occurred.

meals are largely expenditureson the labor used to prepare and serve

the food. The price of these labor serv-ices is less volatile than is the price ofthe raw food products.

Should We PutFood Back into the"Core" Basket?

Because volatility in food priceshas dropped in recent years, does itstill make sense to exclude food fromour measure of core inflation? Are welosing information about the underly-ing trend in inflation by removing sucha stable component from the core?Indeed, by excluding food prices inour traditional analysis of core infla-tion, we lose more knowledge aboutthe trend in inflation than we gain.

The reason for creating a coremeasure of inflation is to learn aboutthe underlying trend. The inflationtrend is caused by monetary policy andshould be reasonably stable over time.Thus, a good core measure will be agood predictor of future inflation. Theall-item inflation rate reported in thenews is a flawed predictor of futureinflation because it contains someitems, such as energy products, thatare quite volatile, causing the all-itemindex to deviate from the underlyingtrend. We exclude energy from thecore in order to get a better measure

components, but it also has been a rela-tively good predictor of future inflation.

Figure 3 compares the food compo-nent of the PCEPI with the PCEPIexcluding food and energy in terms oftheir abilities to predict inflation twoyears into the future. This comparisonis made by going back in time to simu-late a forecasting exercise. Each quar-ter, we record the previous year'sinflation in the food component of thePCEPI and in the PCEPI excludingfood and energy. We then use thesetwo past inflation rates to forecastinflation over the next two years.

For example, in January 1992, we usethe inflation rate for 1991 from bothof these indexes to make forecasts of theaverage inflation rate for 1992 and 1993.The better forecast is simply the onethat is closest to the actual inflation ratethat occurred in those two years. Figure3 plots the forecast errors (predictedinflation minus actual inflation) for thetwo indexes. Looking at Figure 3, wesee that past inflation in food prices hasbeen a better forecaster of future infla-tion than has the popular core measure.Core inflation was more often aboveactual inflation than below it, meaningthat it had a tendency to predict a high-er rate of inflation than actuallyoccurred. On average, the all-itemindex rose at a 3.0 percent annual rate,while predicted inflation from thePCEPI excluding food and energy aver-aged 3.7 percent per year. In contrast,

[8]

Forecast Errorsof Food and PCEPIexcluding Foodand Energy

inflation in food prices appears tobe an unbiased forecast; it was belowactual inflation about as often as it wasabove it, with approximately equallysized errors. Its average predictedinflation of 2.8 percent was only two-tenths of a percentage point belowthe actual inflation rate.

Now that we have identified infla-tion in food prices as a relatively goodindicator for future inflation, we mustsee how it stacks up against othercomponents of the PCEPI. Forecasterscompare results by measuring the sizeof the forecast error. A standard meas-ure of comparison is the root-mean-square error (RMSE), which tends topenalize large forecast errors—the dif-ference between the actual and fore-casted values—more heavily thansmall forecast errors.3 For example,in Figure 3, the PCEPI excluding foodand energy would be highly penalizedfor the big errors in 1983. As we didwith the food component, we use theprevious year's inflation in variouscomponents of the PCEPI as alterna-tive forecasts of future inflation. Wethen calculate the RMSEs to evaluatethe relative accuracy of these forecasts.

Comparing the past year's inflationin food prices to the prices of othercomponents that comprise the PCEPI(as in Table 1), we find that the foodcomponent still ranks the best amongthem all. Food has the smallest RMSE(0.99), while energy has the largestRMSE (10.52). This implies that pastinflation in food has been a good pre-dictor of overall inflation.

The New Core:PCEPI excluding Energy

To assume that the food shocksof the 1970s will never be repeated isprobably dangerous. A glance back atFigure 3 shows that the core measurewas not really too bad if we exclude1983. We include the core measureexcluding food and energy in Table 1 toshow that, with the exception of food,it really is much better than looking atmost of the other component measures.We also show that the measure could beimproved by putting food back into themix. The core measure excluding onlyenergy is about 10 percent more accuratethan the standard measure. (Its RMSEwas only 1.10 percentage points, whilethe RMSE of the forecast error usinginflation in the PCEPI excluding foodand energy was 1.23 percentage points.)

With the decreased volatility in foodprices and their ability to predict futureinflation, it no longer makes sense toexclude food from our measure of coreinflation. Too much valuable informa-tion is lost with the exclusion of foodfrom the core PCEPI. A better measureof core inflation would be the PCEPIexcluding just energy. Looking at Table 1again, we see that the PCEPI excludingfood and energy has a higher RMSEthan the PCEPI excluding energy only.Energy remains a highly volatile com-ponent and masks the underlying infla-tion trend. Removing energy alone, asopposed to food and energy, gives us aclearer picture of the inflation trend.

William T. Gavin is a vice president andRachel]. Mandal is a senior research associateat the Federal Reserve Bank of St. Louis.

The better that past inflation in acomponent of the PCEPI is able toforecast overall inflation, the betteran indicator it is of the true inflationtrend. The root-mean-square error(RMSE) measures how far away aforecast is from the actual measuredvalue and is, therefore, a measure ofhow good a forecast is. Componentswith a smaller RMSE are better atforecasting future overall inflation.Here, we see that food has the lowestRMSE, indicating that we might belosing valuable information abouttrend inflation by removing it fromour measure of core inflation.

77K Regional Economist • January 2002

ENDNOTES

1 For a detailed analysis of the compo-nents of the CPI, see Clark (2001).

2 For further discussions on the changein consumer food preferences andadvances in food distribution technol-ogy, see Johnson, Rogers and Tan(2001); Jacobs and Shipp (1990); andPaulin (1998).

3 The RMSE tests how far away a fore-cast is from the observed/actual value.The test first finds the differencebetween the actual value and the fore-casted value. It then squares this dif-ference and takes an average of all ofthese squared differences. Finally, ittakes the square root of the average,and the resulting number is called theRMSE. The better a forecast is, thecloser to zero the RMSE will be.

REFERENCESClark, Todd E. "Comparing Measures of

Core Inflation" Federal Reserve Bankof Kansas City, Economic Review,Second Quarter 2001, Vol. 86,No. 2, pp. 5-31.

Jacobs, Eva and Shipp, Stephanie. "HowFamily Spending Has Changed In TheU.S." Monthly Labor Review, March1990, Vol. 113, No. 3, pp. 20-7.

Johnson, David S.; Rogers, John M. andTan, Lucilla. "A Century of FamilyBudgets in the United States."Monthly Labor Review, May 2001,Vol. 124, No. 5, pp. 28-45

Paulin, Geoffrey D. "The ChangingFood-at-Home Budget: 1980-1992Compared." Monthly Labor Review,December 1998, Vol. 121,No. 12, pp. 3-32

m

The Ability ofPCEPI Componentsto Predict Inflation