Why Bernanke ignores pain at the pump to gauge inflation

Charles Mead Contributor
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The average American may be paying 36 percent more for a gallon of gas than he or she did last year, but Federal Reserve Chairman Ben Bernanke will likely tell reporters on Wednesday that prices in the U.S. are under control. 

That’s because the Fed, charged with keeping the cost of goods and services stable, ignores food and fuel when it comes to gauging inflation, or rising prices. The central bank instead bases its monetary policy –- along with a mandate for full employment – on “core” inflation, the rise in the cost of a basket of goods such as clothing that are seen as more stable, and therefore a better predictor of future prices.

“When you hear a Fed official talk about core inflation, they’re really talking about the innards of their forecast,” Vincent Reinhart, who directed the Fed’s monetary affairs division from 2001 to 2007, said in a phone interview.

That fact can get lost amid painful price hikes, Reinhart said, when the Fed may seem callous by ignoring the dent high oil costs make in the average American’s checkbook.

“The natural impulse is to say ‘What, you don’t drive or eat?’” said Reinhart, now at the American Enterprise Institute, a conservative think tank. “That is in many ways disconnecting to the public.”

Defining and anticipating the rate of rising prices has huge implications for the country. The Fed is currently finishing up a plan to print money and buy up to $600 billion of government bonds to prop up the economy. High levels of inflation, which can slash the value of savings accounts, could prompt the Fed to stop its so-called “quantitative easing” program and raise interest rates — possibly a dangerous move in a fragile economy.

Critics of focusing on the truncated definition say the central bank is charting dangerous territory by leaving interest rates low and printing money while commodity prices such as oil surge.

Even some central bank policy makers are growing wary that soaring gas and grocery costs, left unaddressed, risk the Fed falling behind the curve and having to overcompensate later with hurried interest rate hikes that could hurt economic growth.

“There is the risk that we might breach our duty to hold inflation at  bay,” Dallas Fed President Richard Fisher said in an April 8 speech. “My gut tells me that this will result in some unpleasant general price inflation numbers.”

But the Fed doesn’t focus on “general price” numbers to set its policy. Policy makers such as Bernanke believe that because the prices of commodities such as oil and wheat can swing wildly, they can distort what’s happening and, more importantly, warp future estimates of inflation.

Inflation affects everything from mortgage rates and car payments to the amount the government has to pay to borrow money. If inflation increases, or is expected to increase, interest rates often follow.

Consumer prices including food and energy rose to a 2.7 percent annual pace in March, with energy costs jumping 15.5 percent, while so-called core inflation increased to only 1.2 percent, according to Labor Department figures released earlier this month.

The Fed generally wants to keep core price gains from exceeding 2 percent, and prefers to gauge inflation with something called the core personal consumption price index, which rose 0.2 percent in February, the same as in January.

The price of crude oil has surged more than 30 percent and topped $110 per barrel since Feb. 15, when protests against Libyan leader Muammar
Gaddafi raised concern among investors that oil supply in the Middle East would be disrupted.

After rising less than 1 percent last year, food costs are expected to jump 3 to 4 percent in 2011, according to the Department of Agriculture. A gallon of regular gasoline in the U.S. reached $3.87 a gallon on April 26, the highest since September 2008, according to American Automobile Association.

The Fed has called such spikes “transitory.”

The use of core inflation to direct monetary policy, Fed Vice Chairman Janet Yellen has said, is in no way intended to downplay the strain on household budgets. It’s just a better tool.

“Core inflation has been a better forecaster of overall inflation in the medium term than overall inflation itself has been over the past  25 years,” Yellen said earlier this month.

There are two risks from an emphasis on core prices. The first is that the public could lose confidence in the Fed’s willingness to combat higher prices, leading to higher expectations of inflation that, in turn, drive up costs.

The second is that rising oil and food costs aren’t just temporary swings.

“You look at core because the changes in food and energy, historically, have just been blips,” Reinhart said. “But what happens if those relative prices are changing on a more sustained basis?”