Rising energy, food costs test Fed core inflation focus

By Mark Felsenthal - Analysis

WASHINGTON (Reuters) - Swiftly rising food and energy costs are challenging the Federal Reserve's practice of focusing heavily on core prices in setting monetary policy, but the central bank shows little sign of changing its thinking.

The Fed's focus on inflation gauges that strip out food and energy prices stems from the belief that these core measures are less volatile and provide the clearest picture of where inflation is heading.

"If inflation expectations are well anchored, changes in energy -- and food -- prices should have relatively little influence on 'core' inflation," Federal Reserve Chairman Ben Bernanke said on Tuesday in an endorsement of the Fed's long-standing reliance on these core gauges.

"One might think of this effort to distinguish transitory from persistent price changes as a more nuanced way of estimating the underlying inflation trend," he said.

But some analysts believe the Fed may be taking too narrow a focus, since some measurements show headline inflation persistently higher than the core yardstick.

"These are the prices that consumers are paying, and they have not been moderating. They have been reaccelerating. So it looks like the core is giving what looks like an increasingly misleading signal about trends," said Julia Coronado, a former Fed economist now with Barclays Capital in New York.

Energy and food account for about a quarter of the U.S. Labor Department's consumer price index -- the nation's most popular inflation gauge. Historically, these costs have been more volatile than prices for the other 75 percent of goods and services that comprise the CPI "basket."

However, food and energy prices have been increasing more quickly than core prices for a number of months, and especially in the case of energy, for much longer.

UPWARD VOLATILITY

While food prices have surpassed core inflation in every month since February, when measured on a year-over-year basis, energy cost rises have outpaced core prices in each of the past four years.

"In the last, really, four years, headline has moved systematically above core," Coronado said. "It is true that food and energy prices are pretty volatile, but they are volatile around a pretty pronounced upward trend."

Consumers are keenly aware of higher prices when they fill their gas tanks or buy groceries, and the greater persistence of these upward energy and food price movements could lead them to think higher inflation is here to stay.

"It must be obvious to the citizenry of this country that there's ... inflation," said Steve Axilrod, a former staff director for monetary and financial policy at the Fed. "One ... definition of inflation is when the (average shopper) notices it in the grocery store."

Expectations of higher inflation could lead workers to push harder for compensating wage gains and businesses to try harder to raise selling prices -- a classic wage-price spiral.

So far, so good, say Fed officials, who regularly proclaim expectations of future inflation are well contained.

While consumers may have become accustomed to persistent sharp gains in energy costs, rising food prices that outpace core inflation are a more recent phenomenon, driven by a shift in the use of corn for the alternative fuel ethanol, as well as greater global demand for foods such as milk, analysts say.

THINK GLOBALLY, ACT LOCALLY

One reason the Fed may prefer to focus on core inflation is because its interest-rate decisions have much more impact on prices of core goods and services than on the prices of energy and food, which are traded globally.

For example, interest rates can have a big impact on housing costs. The "shelter" component -- a subsector of housing that excludes the cost of utilities -- accounts for about 33 percent of the overall CPI.

Andrew Tilton, a U.S. economist with Goldman Sachs, says strong global demand for energy and food, which has pushed those prices sharply higher, may be a long-lasting phenomenon the Fed may have to take into account.

"That's the tricky thing -- if you really have the view that energy and food are going to outpace core inflation over the next five years, it raises the question of whether they should push the core lower" to keep overall inflation contained, he said.

While that may present a challenge for policy-makers, Tilton said the Fed has good reason to focus most intently on core prices.

If it reacted to changes in the price of oil triggered by a refinery explosion or food price swings stemming from a drought, monetary policy would become less dependable, he said.

"You might be moving policy rates around much more and creating more uncertainty about Fed policy and rates and ultimately adding to volatility," Tilton said.