Alan Reynolds

The Federal Reserve's open market committee opted to stop raising the federal funds rate, leaving it at 5.25 percent for the time being. This was no surprise on Wall Street, unlike additional bad news about oil and natural gas, yet it unleashed a barrage of editorial criticism from such leading conservative papers as The Washington Times and The Wall Street Journal.

The Fed's critics make it sound as though the past three months have revealed an enormous spike in "core" inflation (excluding direct energy expenses and, unimportantly, food). On Aug. 2, a Wall Street Journal report said, "The price index for personal consumption expenditures excluding food and energy (PCE) ... rose 2.4 percent in June compared with a year earlier, matching the fastest annual rate since 1995." Comparing the second quarter to the first, that same core PCE index was said to have increased "at a 2.9 percent annual rate, the fastest pace in more than a decade."

The Fed statement remarked that "readings on core inflation have been elevated in recent months," yet predicted that "inflation pressures seem likely to moderate" as a result of past monetary tightening. Contrary to Fed critics, the phrase "baked in the cake" refers to lags between actions and effects, not only to excessively easy policy in 2003.

In reality, the core PCE index rose at the same 0.2 percent pace in April, May and June, leaving only March "elevated" at 0.3 percent. Monthly increases also averaged 0.2 percent during the first quarter and during the last quarter of 2005.

Martin Feldstein's recent Wall Street Journal article worried that "the doubling of the price of oil is being reflected in transportation costs and in the costs of goods that use petrochemical inputs." But all of those indirect energy expenses are included in the core PCE deflator, which is nonetheless still rising at a fairly routine 0.2 percent monthly pace. Prices of oil and natural gas cannot rise forever, and when they stop rising, that 0.2 percent monthly rate (2.4 percent a year) is all that will be left, minus today's elevated costs for transportation and petrochemicals.

Why are these unchanged 0.2 percent monthly increases now being described as the fastest since 1995 when they have not changed since last August? This mass hallucination results from statistical pitfalls involving comparing price indexes from year to year and multiplying quarter-to-quarter changes by four to fabricate an "annual rate."


Alan Reynolds

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