Economix: The Fed’s Language Problem on Inflation

Brendan Hoffman/Bloomberg NewsEric Rosengren, president of the Federal Reserve Bank of Boston.

The Federal Reserve has made clear that it’s not worried about inflation right now, despite spikes in the price of oil, food and other commodities. It has had a harder time explaining why.

Part of the problem is language. The Fed looks for inflation in prices that change slowly, like the cost of cars or clothing. It calls this “core inflation,” which suggests to many infuriated people that the Fed views the cost of food and oil as less important.

Actually, the Fed’s point is that short-term changes in food and oil prices don’t predict long-term changes in food and oil prices. The trend line can’t be trusted. The path of other prices is a better predictor.

Lately, in a bid to address the language problem, the Fed chairman, Ben S. Bernanke, has stopped talking about “core inflation” and started talking about “underlying inflation.”

But the Fed also has a substance problem. It needs to convince skeptics that it’s right — that it can see the future, and that the increases in food and energy prices won’t last.

Eric Rosengren, president of the Federal Reserve Bank of Boston, pressed this case Wednesday morning in a speech arguing that food and energy prices once predicted inflation, but the correlation broke down in the mid-1980s.

Federal Reserve Bank of Boston (Sources: Bureau of Labor Statistics, National Bureau of Economic Research via Haver Analytics)

Mr. Rosengren said the reasons for the change give him comfort that the current spike in prices once again is unlikely to portend broader inflation.

First, he said, we spend most of our money on services, and the cost of commodities has a smaller impact on the price of services. (This is true even of our spending on food: Much of that money actually is spent on processing or packaging or preparation and delivery. An increase in the cost of wheat is a big deal in India, where people eat wheat; it matters less in the United States, where people eat Wheaties.)

Second, inflation gets rolling when workers facing higher prices demand higher wages, allowing them to pay still higher prices, and so forth. As you may have noticed, wages for American workers are increasing slowly at best, for reasons including technology-driven increases in productivity, high unemployment and shrinking unions. The price of food and oil is hurting workers, but they can’t do much about it.

“With compensation slowing and productivity increasing, many firms have been profitable and able to withstand increases in commodity prices without passing such costs on to final prices,” Mr. Rosengren told the Massachusetts chapter of the Commercial Real Estate Development Association.

Federal Reserve Bank of Boston (Sources: Wall Street Journal, Bureau of Labor Statistics, National Bureau of Economic Research via Haver Analytics)

Finally, Mr. Rosengren believes that the Fed has become better at its job.

“I think people are much more confident that the Federal Reserve is going to be consistent about maintaining inflation over the medium term at about 2 percent,” he said.

All of this works better if commodity prices are increasing because of temporary constraints on supply – like disruptions in the Middle East – rather than increased demand from China and other developing countries, which could drive permanent price increases that would be more likely to leak into other parts of the economy.

Mr. Rosengren said he was convinced that supply constraints were the dominant factor, noting the timing of the oil-price increases coincided with events in the Middle East.

If demand is driving the increases, he said, “that would be more of a problem.”

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