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Economic SYNOPSES
short essays and reports on the economic issues of the day
2007 ■ Number 9

Energy Prices: In the Mix or Swept Under the Rug?
James B. Bullard and Geentanjali Pande
he Federal Open Market Committee (FOMC) has
rate, rendering the core measure a misleading trend inflation indicator for policymakers.
responsibility for the long-run inflation rate for the
The problem is this: Instead of simply being volatile,
U.S. economy and therefore needs a reliable indicator
energy
prices moved to a higher level and have remained at
of trend movements of inflation. Currently, the Committee
the higher level. That means that the relative price of energy
focuses on the personal consumption expenditures (PCE)
has increased more or less continuously for the past several
inflation rate—in particular, on the core rate. The core rate
years. Given our relatively inelastic demand for energy, at
excludes food and energy, two components that, since 2000,
least in the short run, all of us consumers were forced to
together account for approximately 18 percent of the index,
spend more on energy and less on all other goods. From this
about 13 percent food and 5 percent energy. Policymakers
source we expect downward pressure on the prices of all
generally consider the energy component, in particular, to
non-energy goods and services. Once the relative price
be too volatile to inform their month-to-month deliberachange is complete, we would expect energy prices to be
tions. But is it a good idea to exclude prices that are, after
volatile around their new, higher level, but again grow at
all, faced by consumers, when trying to read movements
the same rate on average as the prices of all other goods. As
in trend inflation?
the chart indicates, during the transition toward a higher
A trend inflation indicator that is often used is PCE
relative price of energy there was a sustained gap between
inflation measured from one year earlier. The chart shows
the overall and core PCE inflation rates. We conclude that
inflation rate data since 2000. Pictured are the inflation rates
excluding energy prices may not be a good idea during a
for the PCE, the core PCE, and the energy component of
period of relative price change. ■
the PCE. The chart indicates that the energy component is
quite volatile, as expected. If the core PCE
concept is valid, the energy component
should be sometimes above and sometimes
Personal Consumption Expenditures
below the PCE inflation rate, as it was in
Percent Change from One Year Earlier
Percent Change from One Year Earlier
(Energy Component)
2001 and 2002. In this situation, the core
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concept removes a volatile component and
Energy Component of
PCE Inflation Rate
gives the Committee a better indicator of
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trend inflation movements.
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However, the data since 2003 show a per12
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sistent divergence in the overall and core
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PCE
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PCE inflation rates, as the inflation in the
Inflation Rate
energy component has remained high. For
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this time period, excluding energy prices
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simply amounts to putting zero weight on
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the prices that are increasing at the most
Core PCE
–8
Inflation Rate
rapid rate. Accordingly, the chart indicates
0
that the core PCE inflation rate has averaged
–12
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about 1.94 percent per year, while the PCE
–16
–2
has averaged 2.56 percent during this period.
One could interpret this as a sustained
understatement of the true trend inflation
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Views expressed do not necessarily reflect official positions of the Federal Reserve System.

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