Barry said something about inflation and how Bernanke is not measuring it correctly. Then another blogger jumped on it and replied that Barry does not get it. The problem with this discussion is that it is a discussion of concepts and no illustrations.

All right here is the discussion, what is inflation? Is it core? Or is it actual? The ECB measures inflation using actual whereas the Fed measures using core. Core inflation is the rate of inflation without food and energy. Why is the Fed doing one thing, and the Europeans doing another? As explained by DeLong:

The Federal Reserve would rather not do this unless it has no other option. If the rise in inflation is thought to be (a) transitory and thus (b) self-limiting, the Fed would prefer to let sleeping dogs lie rather than hit the economy on the head with a brick.

In layman’s terms it means the following. Let’s say one summer there is a bad apple crop. In the fall the price of Apples will increase and thus you will have to pay more for apples. If inflation included the price of Apples there would be an increase in inflation. But let’s say the next year there is a bumper crop of Apples, then apples would cost less and there would be deflation. By not including the apples in inflation over the two year period there would be no inflation, and a smoother inflation tracking.

Now imagine if apples were summer after summer more expensive. Then when people buy apples they will either buy less apples or in the worst case ask for a raise to pay for the apples. If the person gets a raise then a potential ripple is created where production in the overall food chain gets more expensive and thus shows up in core inflation. This is the argument in that do you measure ripple or result of ripple?

So the Fed has said we would rather measure the result of the ripples and the ECB has said we would rather measure the ripples. Who’s right? I decided to play this out using a spreadsheet and C# program. (download my spreadsheet and my C# .NET program)

The way to understand the calculations are as follows. The spreadsheet is an example single run of a Monte Carlo simulation, whereas the C# program is a complete Monte Carlo simulation. The purpose of the C# program is to compare if measuring core or actual have any advantages or disadvantages. The purpose of the spreadsheet is to illustrate graphically a single run of actual vs core inflation.

The actual inflation rate is made up of core and food/energy. The core inflation rate is a calculation of the core component and a bleed in factor of food and energy. Remember that the overall core inflation rate is influenced by the long term bleed in of food and energy. Since the Fed thinks the bleed in is low I kept the bleed in factor at 10% of total food and energy. I could have used another factor, but you get the idea that there is some bleed in whether that be inflation or deflation.

The complete Monte Carlo simulation illustrates that it does not matter if you base your interest rate decisions on the actual or core inflation rate. In the long run it all averages out to the same average. Thus both the ECB and Fed can choose to calculate inflation however they please.

Though there is a difference, and this is why the Fed is actually wrong. The problem is that the Fed is not consistent. Let me illustrate with a sample run of core vs actual.

Series 1 is core, and Series 2 is actual. Notice how core is lower for a while than actual, and then near the end switches. This is to be expected and desired by the Fed as the core inflation rate acts like moving average that moves less up and down. But there is a place where the Fed dropped the ball, and look at the end of the sequence where the actual interest rate is lower than the core. This is a situation where the Fed dropped the ball and is illustrated using the following interest rate diagram.

Look at the end, see the plateau. This is Bernankes tenure and at that time core was running hotter than what the Fed wanted. Had the Fed followed their rules then they would have raised interest rates. Instead they saw the low actual and decided that core will subside. But that is breaking your own rules and hence Barry is right.