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Governor Frederic S. Mishkin

At the Business Cycles, International Transmission and Macroeconomic Policies Conference,
HEC Montreal, Montreal, Canada
October 20, 2007

Headline versus Core Inflation in the Conduct of Monetary Policy
In discussing and thinking about the conduct of monetary policy, many central bankers focus on
core inflation--that is, a measure of inflation that excludes the rate of increase of prices for certain
volatile components in price indexes.1 The Federal Reserve, for example, pays particular attention
to the rate of growth of the core personal consumption expenditure (PCE) deflator, which excludes
food and energy prices. Indeed, in the presentation of its twice yearly Monetary Policy Report to
the Congress, the Federal Reserve Board reports the projections of Federal Open Market Committee
participants regarding core PCE inflation, not headline inflation, the latter of which includes all
items in the price index. Here in Canada, unlike in the United States, the central bank maintains an
explicit inflation target. The Bank of Canada states its target in terms of the headline consumer
price index, and although this choice of inflation measure contrasts with the Federal Reserve's
preferred index, the difference is not nearly as great as it appears on the surface. In fact, the Bank of
Canada monitors a number of inflation measures and uses core inflation as an "operational guide" in
coming to its monetary policy decisions and discussing these decisions with the public.
Does it make sense for a central bank to concentrate on core inflation? After all, households almost
daily pay for energy and food items--which are excluded from the most prominent measures of core
inflation--when they fill up their cars at gas stations or visit a grocery store. Households,
particularly less-affluent households, spend a major portion of their budgets on food and energy. A
focus on core inflation, which excludes these items, might be viewed as indicating that monetary
policy makers are out of touch with what consumers really care about. Wouldn't it be better for
monetary policy authorities to focus on headline inflation so that they include food and energy in
their monitoring of consumer price inflation?
As I will argue, this is not an either-or decision. It does indeed make sense for central banks to
emphasize headline inflation when determining the appropriate stance of monetary policy over the
medium run, but policymakers also are right to emphasize core inflation when deciding how to
adjust policy from meeting to meeting. Why? Because what central bankers are truly concerned
with--both for the purposes of internal deliberations and for communications with the public--is the
underlying rate of inflation going forward, and core inflation can be a useful proxy for that rate.
Thus, focusing on core inflation can help prevent a central bank from responding too strongly to
transitory movements in inflation.
Why Monetary Policy Should Focus on Core Inflation
Because households care about the prices of all the items they buy, it clearly does not make sense to
pretend that people do not eat or drive. Thus, I have no qualm in stating that controlling headline
inflation, not core inflation, is--along with maintaining maximum sustainable employment--the
ultimate aim of monetary policy. Nonetheless, I will argue that it is still useful for monetary policy
makers to focus on core inflation when deciding how to respond to incoming economic news.
Although monetary policy is capable of controlling overall inflation in the long run, it does not have
the ability to control relative price movements such as those for food and energy. When a cold snap

freezes the Florida orange crop or a tropical storm hits the gasoline refineries along the Gulf Coast,
monetary policy cannot reverse the resulting spikes in prices for fresh orange juice or for gasoline at
the pump. Temporary supply shocks such as these raise the prices of food and energy relative to
other prices and can have substantial effects on inflation in the short run. By including all items-including particularly volatile items like food and energy--headline measures of inflation are
inherently noisy and often do not reflect changes in the underlying rate of inflation, the rate at which
headline inflation is likely to settle and that monetary policy can affect.
Measures of core inflation attempt to strip out or smooth volatile changes in particular prices to
distinguish the inflation signal from the transitory noise. Thus, relative to changes in headline
inflation measures, changes in core measures are much less likely to be reversed, provide a clearer
picture of the underlying inflation pressures, and so serve as a better guide to where headline
inflation itself is heading. Of course, if a particular shock to noncore prices is not temporary but,
rather, turns out to be more persistent, then the higher costs are likely to put some upward pressure
on core prices. Central bankers must always be aware of this risk. However, research has shown
that, over the past twenty-five years or more, headline inflation in the United States has tended to
revert more strongly toward core inflation than core inflation has moved toward headline inflation.2
As that record suggests, core measures often are much better than headline indexes at providing a
first approximation of the permanent changes to inflation.
When headline inflation has an important transitory component, a focus on core measures can help
avoid monetary policy mistakes. If the monetary authorities react to headline inflation numbers,
they run the risk of responding to merely temporary fluctuations in inflation. We can think about
this danger by considering a supply shock, that causes the relative price of energy to increase
sharply, as in fact has happened over the past three years. Let us suppose that we start out with both
headline and core inflation at acceptably low levels.
First, let's consider a supply shock that temporarily raises the price of energy by a large amount. In
this case headline inflation will rise well above its underlying trend as the price of energy rises but
will soon fall well below its underlying trend as the price of energy falls back to its initial level. On
average, inflation will remain unchanged without any monetary policy action. But a tightening of
monetary policy in reaction to the rise in headline inflation would lead to a decline in employment
and inflation; and because of the long lags between monetary policy actions and changes in
economic activity, that decline would occur some time down the road, when inflation would more
likely be at or below its underlying trend. The outcome of such a policy would be a more
pronounced fall in inflation with a decline in employment. Such a policy would be bad indeed
because it would increase volatility in inflation and employment, which is the opposite of what a
central bank should be trying to achieve as it seeks to promote price stability and maximum
sustainable employment.
But what if a supply shock leads to a permanent shift in the relative price of energy? Indeed, almost
all commentators characterize the current oil price shock that way, in part because they see the rise
of new economic powers like China as adding to the demand for energy in the foreseeable future.
Although in that case the rise in relative energy prices is not reversed, the rate of change in energy
prices does not persist: Headline inflation will rise with the increase in energy prices, but once
energy prices reach their permanently high level, headline inflation will revert to its underlying
trend rate. Thus, as long as the permanent change in relative energy prices does not lead to a change
in the underlying trend rate of inflation--a crucial assumption--then headline inflation will come
back down again. This is what we seem to have seen recently in the United States. From a low near
$30 per barrel in late 2003, the price of oil rose to $70 per barrel by the middle of 2006, and it has
stayed high, with the current price more than $80. That move increased headline PCE inflation to
the 4 percent level for a time, but it has since retreated to around 2 percent (figure 1).

Monetary policy clearly can do little about the first-round effects of a permanent rise in energy
prices, which include both its direct impact on the energy component of overall consumer prices and
the pass-through of higher energy costs into prices of non-energy goods and services. But policy
does have a critical role to play in determining the second-round effects associated with changes in
the underlying trend rate of inflation. Such second-round effects are likely to be quite limited as
long as the rise in the relative price of energy does not lead to a rise in long-run inflation
expectations, as has largely been the case in the recent period (figure 1). However, the stability of
expectations rests on the central bank's strong long-term commitment to providing a nominal
anchor, which, as I have argued elsewhere (Mishkin, 2007), describes the situation in the United
States. With such a commitment firmly established, monetary policy then does not need to respond
as much to the temporary rise in headline inflation to stabilize inflation over the longer run. Under
these circumstances, if monetary policy is tightened appreciably in the face of a surge in headline
inflation, the policy would likely be excessively tight and lead to an unnecessary decline in

Because the point about headline inflation is so important, I would like to illustrate it further with
simulations of FRB/US, the model of the U.S. economy created and maintained by the staff at the
Federal Reserve Board. To keep the experiments as clean as possible, I assume that the economy
begins at full employment and with both headline and core inflation at desired levels. The economy
is then assumed to experience a shock that raises the world price of oil about $30 per barrel over two
years; the shock is assumed to slowly dissipate thereafter. In each of two scenarios, a Taylor rule is
assumed to govern the response of the federal funds rate; the only difference between the two is that
in one scenario the funds rate responds to core PCE inflation, while in the other it responds to
headline PCE inflation.3 Figure 2 illustrates the results of these two scenarios. The federal funds
rate jumps higher and faster when the central bank responds to headline inflation rather than to core
inflation, as would be expected (top-left panel). Likewise, responding to headline inflation pushes
the unemployment rate markedly higher than otherwise in the early going (top-right panel), and
produces an inflation rate that is slightly lower than otherwise, whether measured by core or
headline indexes (bottom panels). More important, even for a shock as persistent as this one, the
policy response under headline inflation has to be unwound in the sense that the federal funds rate
must drop substantially below baseline once the first-round effects of the shock drop out of the
inflation data. Responding to headline inflation is therefore inappropriate because it generates
extensive variability in the unemployment rate--variability that is much more subdued when policy
responds to core inflation.4

Of course, the pitfalls associated with reacting to realized headline inflation, as illustrated by this
simulation, are well understood. Accordingly, advocates of targeting headline inflation generally
have in mind a strategy of responding to forecasts of headline inflation--forecasts that try to take
account of inflation movements that are likely to be transitory. This is a further illustration of my
basic point, namely, that it is important to distinguish between transitory and persistent inflation
movements, and focusing on core inflation can help achieve that end.5
The focus on core instead of headline inflation--and clear communication with the public about that
focus--can have another benefit: It may help anchor inflation expectations when headline inflation
increases temporarily but core inflation remains essentially unchanged. If the public understands
that the central bank is using core inflation in formulating monetary policy and trusts that the central
bank is right to do so, the public will realize that the central bank does not need to respond
aggressively to a surge in headline inflation to keep inflation under control. And, with core inflation
stable, the public will be less likely to think that the central bank has weakened its commitment to a

strong nominal anchor when it does not tighten monetary policy to stabilize headline inflation. The
result is that inflation expectations are likely to remain anchored, which may lead to better outcomes
not only on inflation but on employment as well, because the central bank will not have had to
tighten monetary policy as much in response to the energy price shock. As I noted earlier, figure 1
offers some support for this view: It shows that the rise in headline inflation in the 2004-06 period,
when core inflation remained quite stable, did not lead to an appreciable rise in long-run inflation
expectations, even with a substantial decline in unemployment during this period.
Is Inflation Excluding Food and Energy the Best Measure of Underlying Inflation?
The most popular core inflation measures used and published in the United States are quite
straightforward: They simply exclude changes in food and energy prices. However, such simple
"exclusion" measures can likely be improved upon. For example, many of the food categories
excluded in the standard measure of core inflation, such as food away from home (restaurants), are
not highly volatile and so likely should remain in an optimal core inflation measure. On the other
hand, some items that are not excluded from the U.S. core measures, such as airline fares, tobacco,
and apparel, are extremely volatile and thus are unlikely to be included in an optimal core inflation
The Bank of Canada, for example, uses a more targeted approach to its core inflation indicator, the
CPIX. Of fifty-four consumer product categories, it excludes eight, which account for about 16
percent of the consumption basket (Macklem, 2001). Most of the eight items are also excluded
from the standard core measure in the United States. However, Canada's CPIX also excludes
intercity transportation and tobacco, which are included in the U.S. core measures.6
Another approach to estimating core inflation measures is statistical, in which certain prices are
excluded at each point on the basis of statistical criteria. Among these statistical measures are
trimmed indexes, such as the trimmed mean and the weighted median consumer price indexes
produced by the Cleveland Fed and the trimmed mean PCE price index produced by the Dallas Fed.
Each month, these measures throw out the components with the largest price changes, both positive
and negative (though the Dallas measure is asymmetric).7
Other approaches to estimating core inflation are theory-based measures employing common trends,
unobserved components, or a particular model of the economy.8 However, these theory-based
approaches tend to be rather complex and require faith that the model they are based on is the right
Each of these measures of core inflation can be evaluated according to a variety of criteria,
including the ability to forecast headline inflation over some period and the degree of correlation
with alternative definitions of trend inflation. According to some of these criteria, statistical and
theory-based approaches are sometimes found to outperform simpler exclusion measures of core
inflation, like the standard one excluding food and energy. As you can tell, this is an active area of
research, but recent research done at the Federal Reserve Bank of New York on U.S. data finds that
no one particular core measure, including the standard one, dominates the others: The relative
performance of different core measures varies depending on the choice of the price index, the
sample period, and the criteria for evaluating their performance (Rich and Steindel, 2007). Research
on Canadian and U.K. data comes to similar conclusions (Hogan, Johnson, and Laflèche, 2001;
Mankikar and Paisley, 2002).
Does the lack of empirical support for any one particular type of core measure suggest that our focus
on the standard core measure should be abandoned? I think not. The simplicity and long history of
the standard core measure that excludes food and energy gives it several major advantages. Its
simplicity makes it straightforward to explain and thus more understandable to the public-assuming, of course, that we successfully communicate that we recognize the importance of food
and energy items in people's consumption. Its simplicity also makes its estimation very transparent.
That transparency and the fact that it has been around a long time--hence the characterization as
"standard"--both prevent a central bank or a government authority from easily manipulating the

measure to show good results. These features of the standard core measure therefore make it a
credible device to keep inflation expectations anchored when supply shocks occur: If the standard
measure remains stable, then a surge in headline inflation is less likely to unhinge inflation
expectations, which as we have seen can lead to both better inflation and better employment
Why Central Banks Should also Focus on Headline Inflation
Despite the advantages of core measures of inflation, their use in conducting monetary policy has
been criticized.9 Core measures of inflation attempt to remove the most volatile or transitory
components of the inflation measure. But, because the nature of price shocks may change over
time, items that have been highly volatile in the past may not be so in the future; hence, any core
measure will itself likely be subject to transitory shocks. Unfortunately, as noted above, empirical
research suggests that no one measure of core inflation will work in all situations. Therefore, central
banks do not focus solely on core inflation; rather, they devote considerable resources to
understanding inflation developments in an effort to distinguish signal from noise in the incoming
Another reason to keep watch over the broader inflation picture is that, if the rate of change in the
price of an excluded item receives a permanent shock, then the headline inflation rate can deviate
from the core measure for an extended period of time. The longer this period of high headline
inflation persists, the greater is the risk of second-round effects as the public begins to build this
higher inflation into its expectations. For example, from 1987 to 2002, energy price shocks appear
to have been temporary in that energy prices were mean reverting; as a result, in this period, the
average difference between core and headline PCE inflation was quite small. Since 2002, however,
the effect of energy price shocks have been more persistent, and headline inflation has averaged
more than 1/2 percentage point above core inflation over this period. Over the past year, energy
prices have about leveled off on balance--or at least that was the case until a couple of weeks ago-and the rate of headline inflation for most of this year has come down close to that for core, one
hopes alleviating the risk of second-round effects. But the increases in oil prices in recent days
provide another reminder that shocks can persist longer than one might have at first expected.
A prolonged divergence between core and headline measures of inflation could complicate central
bank communications with the public because core inflation would require some adjustment before
it would provide a clear gauge of underlying inflation. For example, the weighted median CPI
inflation rate, one popular measure of core inflation, has tended to be a biased measure of headline
inflation. The weighted median is exactly equal to owners' equivalent rent nearly half the time
because that component has an extremely large share of the consumption basket and fairly low
volatility (Bryan and Pike, 1991; Hogan and others, 2001; and Bryan and Meyer, 2007). However,
the productivity growth rate in residential construction is not terribly high, and so this sector is
likely to have below-average productivity growth and above-average price increases. Indeed, the
weighted median CPI exceeded overall CPI inflation on average by 1/4 percentage point per year
over the decade from 1992 to 2002, a period when changes in energy prices were transitory. Of
course, to the extent that such a bias in a core inflation measure is stable or predictable, the central
bank could easily take this into account in setting monetary policy. But even in that case,
differences in average rates of inflation between the core measure and overall inflation could
complicate communication with the public.
I have argued that a measure of core inflation that is easily understood and provides some greater
signal about persistent movements in inflation than does headline inflation itself is extremely
valuable for the conduct of monetary policy, and that is why the Federal Reserve pays so much
attention to such measures. However, I have also argued that core measures have their limitations.
A single core inflation measure cannot account for all types of shocks and can at times be
misleading about what is happening to the underlying rate of overall inflation. And if increases in
headline inflation prove more persistent than initially expected, central bankers must be vigilant to
ensure that they do not become embedded into expectations and thereby generate substantial
second-round effects on inflation. Finally, because price stability ultimately involves control of

overall, headline inflation, which after all is the inflation measure that households really care about,
central bankers should and do pay attention to headline inflation as well as to core inflation
measures. A core inflation measure should not be seen as a substitute for thorough and careful
analysis of the forces that are driving our economy and the inflation process.

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1. I thank Alan Kackmeister, Jean-Philippe Laforte, David Lebow, Deb Lindner, and Robert Tetlow
for their comments and assistance. The speech reflects my own views and not necessarily those of
others on the Federal Open Market Committee. Return to text
2. These tests allow for a nonzero constant differential between headline and core inflation. The
differential often turns out to be nontrivial and statistically significant. Cogley (2002) uses
published CPI over the period from 1967:Q2 to 1997:Q4 and finds that it may take about 8 quarters
before there is substantial reversion of headline inflation to core inflation. Clark (2001), using 12month CPI inflation from 1967 to 2000 finds little reversion over the next 12 months but about 50
percent reversion over 24 months, though that level is still statistically insignificant. In contrast, he
finds substantial and statistically significant reversion at both the 12- and 24-month horizons using
data from 1985 to 2000. Rich and Steindel (2007) find significant reversion of headline CPI
inflation to core CPI inflation over 12 quarters using methodologically consistent CPI data from
1978 to 2004. An earlier version of their work (Rich and Steindel, 2005) showed similar results
using PCE price inflation in the 1978-2004 and 1959-2004 periods. Internal work conducted at the
Federal Reserve using 15-year rolling-window regressions suggests that the reversion of headline
PCE inflation to core PCE inflation has been much stronger in samples that start after the early
1980s and also that the reversion of core inflation to headline inflation has been much weaker in that
Results for other countries are more ambiguous. In recent years, Canada appears to have had a
similar reversion of headline inflation to their version of core inflation, along with little reversion of
core inflation to headline inflation (Laflèche and Armour, 2006; also, Armour, 2006; Hogan,
Johnson, and Laflèche, 2001). However, the OECD (2005) has found that many countries show
little reversion of headline inflation to core inflation and that, in fact, core inflation often reverts to
headline inflation. Return to text
3. The Taylor rule is written as follows:
where is the four-quarter
inflation rate, either core or headline,
is the inflation target, taken to be the baseline inflation rate,
and is the output gap. This specification means that the response coefficients on each gap variable
is 1. Return to text
4. These scenarios were constructed using a rule that assumes no prior knowledge of how long the
oil price shock will last. Research done by the staff at the Federal Reserve Board using other types
of models also suggests that when the persistence of shocks is uncertain, using core inflation rather
than headline inflation in central bank reaction functions can improve policy outcomes (Bodenstein,
Erceg, and Guerrieri, 2007). Return to text
5. Economic theory also suggests an additional argument for focusing on a core measure of
inflation. Because some prices are "sticky," meaning they move sluggishly in response to shocks,
higher inflation generates greater dispersion of relative prices and, with that, a misallocation of
resources. Responding to a core inflation measure, which puts more weight on sticky prices, can

minimize this distortion and promote relative prices that better reflect the true underlying demand
and supply conditions in the economy (for example, Aoki, 2001; and Woodford, 2003, chap.
6). Return to text
6. Canada’s CPIX also excludes mortgage interest costs, which are never included in measures of
U.S. consumer prices because the prices of owner occupied housing services are measured on a
rental equivalence basis in the United States. The other items excluded from the CPIX are fruits,
vegetables, gasoline, natural gas, and fuel oil and other fuel. Return to text
7. Bryan and Cecchetti (1994); Robalo Marques, Duarte Neves, and Morais Sarmento (2003);
Dolmas (2005); Brischetto and Richards (2007); Smith (2004). Return to text
8. Recent examples include: the common trends approach of Bagliano and Morana (2003), the
VAR approach of Quah and Vahey (1995); the unobserved components approach of Doménech and
Gomez (2006) and Velde (2006); and the factor-models approach of Cecchetti (1997) and
Cristadoro and others (2005). Return to text
9. Laidler and Aba (2000); Clinton (2006); and Bean (2006) are critical of responding to core
inflation; Blinder (2006) argues on the other side. Return to text
10. More details on inflation forecasting at the Board are in Bernanke (2007). Return to text
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