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.