David Shulman is a retired Wall Street executive who is now a senior economist at the UCLA Anderson Forecast. He is also affiliated with Baruch College (CUNY) and the University of Wisconsin.
Amidst all the hoopla surrounding the Federal Reserve's announcement yesterday of long term policy, the Fed statement was very clear that the relevant measure is the deflator for personal consumption expenditures, which is the broadest measure of prices in the economy. The Fed made a fundamental policy change in moving away from the concept of core Consumer Price Index which excludes food and energy, as its key inflation measure. Their exact words were,
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate targets.
The concept of core CPI was invented in the early 1970s by then-Fed Chairman Arthur Burns to allow for an easier monetary policy in the face of rapidly rising oil and food prices. The economic argument for this new concept of inflation was that it avoided transitory elements driving the inflation rate. However, as we all know energy prices have risen inexorably higher over the past four decades.
Thus the Fed's experiment with unusually low interest rates for a very long time could run aground if it triggers another commodity price bubble as it did last year. If the 2 percent target is for real, the Fed could very well be tested sooner than it would like.
The flip side of the policy change is that housing is weighted far lower in the consumption deflator than it is in the Consumer Price Index. Thus the incipient inflation in rents will be downplayed in the new measure. Perhaps the Fed is fearful that rising rents would make it difficult to maintain its zero interest rate policy going forward. Time will tell.