Mester weighs in on using “sticky” prices in inflation models

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Mester speaks on alternatives to headline PCE

Dr. Loretta Mester spoke about monetary policy and inflation at the Cleveland Fed’s inaugural conference on inflation on May 30. In her speech titled “Inflation and Monetary Policy: Six Research Questions,” Mester focused on the economic importance of price stability and how different measures of inflation can reveal varying price trends. In her speech, she asked six questions to the audience, urging researchers to make advances in inflation forecasting models based on these challenges to monetary policy. This part of the series will discuss her views on the third question: would households and businesses be better off if the central bank chose to target an inflation measure other than headline inflation?

What are sticky prices?

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Several economists contend that using sticky prices to compute inflation would reduce the volatility brought about by the prices of certain components that tend to fluctuate more than others. “Sticky prices” refer to the prices of those goods and services that tend to respond more slowly—that is, increase or decrease less frequently—due to changes in the economic environment. To cite an example, the prices of food commodities like wheat and soy tend to fluctuate daily. However, the prices of cereal charged by consumer packaged goods companies like General Mills aren’t revised as frequently.

Core goods prices have trailed service sector prices

According to Mester, core price inflation in the services sector has ranged between 2.25% and 2.50% since 2012. A deceleration in core goods prices has resulted in headline inflation falling below the Fed’s long-term inflation goals. Mester cited the example of the inflation model developed by the Cleveland Fed and now provided by the Federal Reserve Bank of Atlanta.

According to Mester, “Even a less crude measure of flexible versus sticky price inflation, which was developed at the Cleveland Fed and is now provided by the Federal Reserve Bank of Atlanta, shows that sticky price inflation has been relatively stable around 2 percent. To the extent that the model is valid, this paints a more benign view of recent inflation, one that could have implications for the appropriate path of monetary policy. Of course, these models are simplifications, based on several assumptions, and not ready to be used for setting monetary policy. However, I think this example provides ample motivation for further research on alternative measures of inflation and modeling.”

Implications for investors

The use of only sticky prices and service sector prices in inflation computations would tend to give an incomplete picture of inflation. While excluding the more volatile components from inflation measures may enable better comparisons, headline inflation will provide a more comprehensive picture of the price environment. Economists and analysts would tend to focus on both measures, as inflation expectations impact required rates of return on both stocks (SPY) and fixed income (BND) securities. Inflation expectations are also priced in to the U.S. Treasury (TLT) yield curve, affecting yields on both investment-grade (LQD) and high-yield (JNK) debt.

In the next part of this series, we’ll discuss the variables used by economists to forecast inflation.

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