24th November 2016

BNY Mellon: Why not all inflation measures are created the same

Central banks have long adopted inflation targeting on the premise that low and stable inflation will promote long-term economic growth. But in our view there are inherent problems associated with inflation targets, particularly when it comes to deciding which inflation measure to use.

The Federal Reserve (Fed), for example, targets the price inflation measure for personal consumption expenditures (PCE) at 2%. Like most central banks, the Fed targets the core inflation measure, arguing that volatile factors such as food and energy prices should be stripped out.

But, what if core PCE is giving a misleading picture of inflationary pressures in the US economy? Each measure of price inflation has components that are weighted differently and the sensitivity of each to the business cycle can vary. Some sectors may also be more prone to experiencing large idiosyncratic shocks compared to others. Other forms of aggregation can be used, further complicating the picture.

The suggestion that the inflation target itself may be flawed is interesting, given the effort investors pour into dissecting every line of monetary policy communication from central banks for clues as to the next move in interest rates or, as the case has been more recently, unconventional policy settings. The issue reminds this fund manager of Goodharts law, named after Charles Goodhart a former advisor to the Bank of England who first opined in 1975 that “when a measure becomes a target, it ceases to be a good measure”.

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