Core inflation losing accuracy as price predictor

Shoppers manoeuvre their way through an aisle at Costco Warehouse in Arlington, Virginia, May 29, 2008.

BASEL (Reuters) - Strong rises in commodity prices mean core inflation has lost some of its effectiveness as a predictor of headline price pressures, the Bank for International Settlements said on Monday.

In its annual report, the BIS said the past follow-the-leader relationship between core and headline inflation had been distorted by food and energy price rises.

"The prolonged rise in commodity prices in recent years has weakened this relationship," the BIS said.

The findings raise questions about the use of core inflation in divining future inflation trends, an approach used by central banks including the U.S. Federal Reserve.

Food and energy costs are typically stripped out of core inflation measures, and the recent trend means core inflation has been relatively low while headline rates are soaring.

U.S. core inflation is running at 2.3 percent --just above the 2.0 percent ceiling seen as the top of the Fed's comfort zone -- while the headline rate was 4.2 percent in May.

In the euro zone, where the ECB has dismissed core inflation as a predictor of headline inflation, price growth excluding energy and unprocessed food was 2.5 percent, compared with the headline rate of 3.7 percent.

The BIS said in the past, headline inflation had tended to follow core inflation because food and oil price increases were usually due to glitches in supply, and later reversed.

But since 2003, when energy prices started to trend upwards on the back of strong demand in emerging economies, calculations show the link has weakened in the United States and the euro zone, although not in Japan.

The BIS also raised doubts about the accuracy of measures of inflation expectations, a key focus for central banks keen to prevent current high inflation rates from sparking higher wage demands and influencing corporate price setting.

Market-based measures of inflation expectations increased in 2007, particularly in the United States, and household survey estimates had also risen although they remained below 1980s levels.

But the BIS said it was not clear whether inflation expectations were primarily forward- or backward-looking. In the latter case, they could have been influenced by low inflation rates in recent years, and could also suffer from high food and energy costs pushing up perceptions of inflation.

"The simple fact that long-term inflation expectations have apparently remained well anchored over the past few years does not provide a decisive indication of whether, and how strongly, these expectations might be reversed, nor what could trigger such a reversal," the report said.

For a copy of the annual report, please see the Website:

www.bis.org

(Reporting by Krista Hughes; Editing by Ruth Pitchford)