Inflation Target May Be Shifting

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By Nell Henderson
Washington Post Staff Writer
Wednesday, June 27, 2007

If investors and financial analysts could ride in the back seat of Ben S. Bernanke's 1998 Chrysler Sebring convertible, many would be whining that familiar summer refrain: "Are we there yet?"

They'd hope to hear from the Federal Reserve chairman that the nation's central bank has reached its goal of bringing inflation under control. For months, Wall Street has been begging for a signal that the Fed is done increasing interest rates to slow the economy, an inflation-fighting measure.

It isn't likely to happen. As they meet today and tomorrow to review monetary policy, Bernanke and his Fed colleagues appear reluctant to declare victory, even though inflation has eased in recent months. On the contrary, they are likely to say they want inflation to keep falling and are concerned about the risk that it could flare up again. That means they won't lower borrowing costs anytime soon.

Many investors and analysts cheered recently when they thought inflation had subsided. The central bank's preferred core inflation measure, which excludes food and energy prices, dipped in April to 2 percent. That is within the range of 1 to 2 percent identified by Bernanke and others as their comfort zone for core inflation.

But that's still not good enough for some members of the Fed's top policymaking committee.

After years of focusing publicly on core inflation, its members are paying more attention to broader measures that include the cost of fuel and food. Those items have long been dismissed as too volatile to shed much light on long-term inflation trends -- they can rise or fall rapidly in a short period.

But for nearly five years, food and fuel prices have done a lot more rising than falling, and some economists say they have become a sustained source of inflationary pressure. With forecasts calling for strong global economic growth, international competition for commodities such as oil, corn and other grains is heating up, driving the price increases. Another factor is renewed interest in ethanol, which is causing increases in the price of corn, which is used to make ethanol in the United States. That, in turn, makes meat, eggs and dairy products more expensive because corn is a primary feed for cows, chicken and other livestock.

In their meetings over the next two days, members of the Fed's top policymaking committee are expected to discuss whether to highlight their concerns about overall inflation in a written statement, a step that could look like moving the goal posts to investors accustomed to the central bank's emphasis on core figures.

If the Fed shifts its focus from core inflation to overall inflation, "it would unnerve more than a few market participants," potentially causing mortgage and other long-term interest rates to rise, said David Shulman, senior economist with the Anderson Forecast at the University of California at Los Angeles.

This creates a communication challenge for Bernanke, who has long argued that the Fed should express its goals as clearly as possible, both through its words and by adopting a numerical inflation target. The financial market's expectations for interest rates affect stock prices and help determine mortgage rates and other borrowing costs for consumers and businesses.

"In our view, the Fed is at a critical juncture," said Laurence H. Meyer, a former Fed board member and now vice chairman of Macroeconomic Advisers. With core inflation at 2 percent, "it's important for the committee to make clear where it wants to go," Meyer said. "Is it satisfied? Is it done? Or is it committed to moving inside the comfort zone" by forcing inflation lower?

Meyer remains in close contact with members of the Fed committee. He said there may be "an emerging consensus" to aim for a 12-month change in consumer prices that is "close to but below 2 percent," as does the European Central Bank.

The Fed began focusing public attention on a Commerce Department inflation gauge known as the core personal consumption expenditure price index, or core PCE, under Bernanke's predecessor, Alan Greenspan, who stepped down in January 2006.

Economists had determined that core inflation measures served as better predictors of overall inflation because they excluded food and energy prices, which could swing with the weather or geopolitical events. One bad frost in Florida could wipe out an orange harvest and briefly push up juice prices, or turmoil in an oil-producing nation could temporarily send fuel prices higher.

But Commerce Department figures show that overall inflation persistently outstrips core inflation these days. Consumer prices, for example, rose 2.2 percent in the 12 months that ended in April, and core prices rose 2 percent.

The difference may not be huge, but it worries Fed policymakers because the expectations of consumers and businesses about future price increases can be self-fulfilling -- consumers may be more willing to pay higher prices now if they expect them to keep rising, while a business may raise prices because it believes it will have to cover higher costs and wages. Expectations also are influenced by perceptions of overall inflation: Even if core prices are well-behaved, people still have to eat and buy gasoline.

It's costing more to do both. Pizza Hut and Papa John's recently raised the price of their cheese pizzas and Cheesecake Factory plans to increase its menu prices because of rising dairy costs. General Mills said it would raise cereal prices this week to help offset higher grain and fuel costs. And gasoline prices have topped $3 a gallon in much of the country since early spring.

According to the Labor Department, which has separate measures for inflation, energy prices were up 4.7 percent and food prices were up 3.9 percent in the 12 months that ended in May.

"The core was created because food and energy prices were volatile. But when they are up and they remain up, the Fed must be very concerned," said Eugenio J. Alemán, senior economist at Wells Fargo Bank. "If gasoline and food prices cause a change in expectations, we are doomed because the Fed will have no choice but to raise interest rates."


© 2007 The Washington Post Company

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