The era in which central bankers could apparently do no wrong ended emphatically in 2008. Since then, they have attracted plenty of criticism as they have adopted a succession of unconventional policies to stabilise the world economy and financial system. But now they could be facing an even more difficult problem – a commodity price shock which simultaneously raises headline inflation while also slowing the recovery from recession. The recent orthodoxy among central bankers is that they should ignore commodity price shocks because they are quickly self-correcting. Headline inflation will rise, but core inflation will not, so interest rates can be left unchanged. But does this orthodoxy need to be revised?
The orthodoxy about headline and core inflation is held most firmly by the US Fed. Yesterday’s speech by Ben Bernanke re-affirmed this set of beliefs in notably strong terms. He acknowledged that the economy is recovering (and his tone was a little more optimistic on that front than the most recent FOMC minutes), but he emphasised that core inflation would remain very subdued because unemployment and spare capacity are still very high. Therefore core inflation, and wage inflation, remain very subdued. The rise in oil and food prices, which are likely to impact the headline inflation rate considerably in the next few months, were given very short shrift.
This, then, is the orthodoxy. Spare capacity (usually measured by the output gap) determines the core inflation rate. Increases in commodity prices can, from time to time, lead to variations in the headline inflation rate, but these will fairly quickly be eliminated as long as the central bank remains focused on the long term path of the core inflation rate. The two most significant danger signals would be an increase in price expectations, or a rise in wage settlements. Since neither of these signals is flashing red, or even amber, in the US, the Fed remains super dovish. In fact, someone described it recently as “uber” dovish. And the Trichet press conference on Thursday suggested that the ECB is in a somewhat similar mood, though it is much less convinced than the Fed. Perhaps their mood could be described as “unter” dovish.
The evidence in the past 15 years, especially in the US, is very supportive of the orthodox point of view. 
The first graph shows that the core inflation rate in the US has been very closely related to the size of the output gap, with a one year lag existing between the two variables. This relationship was nowhere near as close prior to the mid 1990s, but since then it has been very hard to gainsay. With the current level of the output gap around -4 per cent, there is no reason to believe that core inflation is about to take off. It might rise slightly from the current very subdued rate of 0.7 per cent, but this in any case is far too low for comfort, as the Fed keeps on saying.
That is all very well, but what about the food and energy price shock which is is now hitting the economy? Will this eventually cause an unacceptable rise in core inflation?
Again, the evidence of the past 15 years suggests that Fed’s current orthodoxy is justified. As the second graph shows, the core inflation rate in the US has been completely unaffected by the behaviour of headline inflation since the mid 1990s. Increases in commodity prices (for example in 2008) have caused temporary fluctuations in headline CPI inflation, but the trend in core inflation has barely budged. This has also been true in the eurozone, but again the evidence is a lot clearer in the US than in Europe.
All of this suggests that the Fed, and probably the ECB, should be very reluctant to raise interest rates in response to a rise in commodity prices, when there are no signs of any increase in price expectations or wage settlements. So why is this a potential nightmare for the major central banks?
Here is the problem.
There is a very big difference between a self-reversing up-and-down cycle in the commodity markets, and a longer term upward trend in commodity prices relative to the prices of goods and services produced in the developed economies. Because commodity prices are determined in competitive markets which need to clear at any point in time, they tend to fluctuate much more over short periods than the “sticky” prices and wages which exist in developed economies. If they are simply fluctuating around a constant or slowly rising trend, then they will quickly self-correct and the central bank should stay focused on the core inflation rate which is set in the rest of the economy.
But what if commodity prices are instead embarked on a long term uptrend against the prices of goods and services in the developed economies, driven by the rapid growth in the emerging economies? In that case, the commodity price shock would have a permanent effect on input prices in the developed economies, and it would not be appropriate for the central banks to ignore this shock. In fact, if they ignored it, they would simply be accommodating a permanent inflation shock to the system, which is what they did in the inflationary 1970s.
So it is a very difficult judgment. My own view, based on the arguments above, is that the central banks are justified in waiting for more data before concluding that the rise in commodity prices is permanent. But the economic evidence for this point of view is stronger in the the US than it is in the eurozone; and it is stronger in the eurozone than it is in the UK.
And that is why the Fed is the most reluctant of all the major central banks to reconsider the comfortable orthodoxy of the last 15 years, even as commodity prices continue to rise.
