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