For monetary policy to work, it is essential that central banks target the correct inflation measure. There are a number of differences in the way that inflation can be calculated – for example, the Bank of England and the ECB target headline inflation, while the Federal Reserve focuses on core inflation (which strips out energy and food prices). If central banks are looking at the wrong inflation measures, and there is a real risk that they are, then there could be serious implications for global bond markets.
Why does the Fed only focus on core inflation, when food comprises 15% of ‘total’ US inflation and energy forms nearly 9%? The answer is not that the central bank is pretending that food and energy don’t exist – rather it is because these components tend to be very volatile and very short lived, being more to do with whether there’s been a political scare or a hot summer than being part of any long term economic trend. Food and energy can therefore distort the ‘true’ picture of inflation, and given the lag involved (at least 12 months) between changes in monetary policy and its effect on the wider economy, an overreaction to a short term fluctuations could be disastrous.
But what if the recent change in food prices and energy prices is not actually temporary at all? Soaring food and energy prices have meant that headline inflation has averaged around 0.5% higher in OECD countries since the beginning of 2003, and if you believe that the long term trend is for food prices to climb higher (think global warming) or for oil prices to continue rising (perhaps because of Peak Oil), then there is a real risk that the Federal Reserve is significantly underestimating inflationary pressure. One high profile critic of the Fed’s focus on core inflation is Charlie Bean, who was formerly my personal tutor at LSE in the 1980s but is now the Bank of England’s Chief Economist. He argued last year that higher food and energy costs are a by-product of Chinese demand and globalisation, so in calculating inflation, it makes little sense ignoring the higher inflationary effects of globalisation (energy costs) while at the same time including the disinflationary benefits of globalisation (cheaper manufactured goods).
Even if we assume that the recent rise in food and energy prices are here to stay, the ECB and the Bank of England will most likely only begin to take firm action when these inflationary pressures turn into so called ‘second round effects’ in the form of higher wages. Wage growth in the developed world has been incredibly low over the past five years, with real wage growth in most of the developed world being negative as a result of global competition and immigration. However, there is evidence that the workers are demanding more (we first commented on this back in December), and if wages do rise then central banks will certainly clamp down with higher interest rates.