Sunday, October 30, 2011

Headline and core inflation - no link with commodities?

From the FRBSF Economic Letter: Does Headline Inflation Converge to Core, we see that commodity prices will not drive inflation. In reality, the headline and core inflation mix has changed.  Pre-1993 there was a strong movement between headline and core. Inflation persistence was higher than the 70's and 80's and has fallen in the last twenty years. In the post '93 period there is not a close link. The conclusion is that inflation expectations are well anchored, but this is an observation and not an explanation. Some researchers have argued that the delink is caused by the widening employment gap. 

I would argue that the decoupling has to do with a greater focus on inflation targeting by the Fed. The Fed will keep rates within a range and not allow the headline effects to be monetized. If there is a change in Fed behavior with less focus on inflation, expectations will become more focused on headline prices. The result may be a return to the '70's. 

This delinking also explains why commodity investing has not be as effective hedge for inflation. Inflation expectations are rangebound which results in a lower correlation with a basket of commodities. 

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