21/01/2010: How central banks focus on the core and miss the point

Only a couple of years ago, in those distant days when former US Fed President Alan Greenspan still enjoyed the nickname "Maestro," being a central banker was a relatively easy job. Academics had it all figured out. The mission of central banks, explicitly or implicitly, was "inflation targeting."

In 1998, current Fed President Ben Bernanke coauthored a 400-page compendium that examined the mission of central banks in various countries. Back then, the banks' track record was excellent. After all, they vanquished the hefty inflation of the late 1970s and early 1980s.

But there were some discordant voices heard amid all the applause. One line of argument asserted that the line of causality was blurry between the low inflation environment of the 1990s and the actions of central banks. Globalization and the IT revolution could also take some credit for the taming of inflation, ran the argument.

Another critique, one that has been heard often since the financial crisis erupted, stressed the state of denial that central bankers adopted when confronted with obvious speculative bubbles.

In a similar vein runs still another argument. When targeting inflation, central bankers will not focus on the overall inflation figure but on so-called "core" inflation, which conveniently strips out some of the most volatile and painful components for the public, namely food and oil prices.

Why do central banks employ the selective blinders of core inflation? Because, they say, there is nothing an individual central bank, especially a small one, can do about oil prices, which are set on international markets and often influenced by politics and cartels, not merely supply and demand. This tunnel-vision view of inflation leads to the paradox that despite running inflation rates of 2.7% in the US and 2.9% in the UK, both the US Fed and the Bank of England are (rightly) concerned looming about deflationary pressures.

Granting that central banks cannot individually move oil prices, they could have an impact through collective action, couldn't they? But central banks do not play well with others, it seems. There was some cooperation at the peak of the financial crisis, but now central banks have returned to their individual, often uncoordinated ways.

We see some very clear consequences from this go-it-alone mentality. For one, it will lead to high volatility on the currency markets and it also assures a persistent overhang of liquidity internationally, with the concomitant risk of creating new speculative bubbles. We think oil be a candidate here.

Ultimately, headline inflation – the cost for a fixed basket of goods – may also trend significantly higher. But most central bankers will certainly dismiss such a bounce, citing "special factors" and continuing to focus on the core rate. Whether this really helps the public remains an open question.