Editor Pick: Will the Real Inflation Please Stand Up?

A better way to identify underlying inflation in the U.S.

Headline and core inflation measures in the U.S. have been diverging for most of this decade. Harm Bandholz from the UniCredit Group believes it may be time for the Fed to switch back to headline (includes food and energy) as the preferred measure of inflation. The Cleveland Fed and the Dallas Fed already publish alternative measures that do not categorically exclude food and energy: a median and trimmed mean CPI by the former and a trimmed mean PCE deflator by the latter.

Better yet, Bandholz suggests, how about a volatility-weighted price index?

Volatility-weighted measures of underlying inflation include all CPI components but give less weight to the more volatile ones. More precisely, the weight assigned to each component is derived from the standard deviation of the respective m-o-m price changes: The higher the volatility, the lower the weight and vice versa. The idea is that a measure of core inflation should minimize volatility in order to give a clear indication of the underlying inflation path. Hence, in contrast to the CPI ex food & energy that, in times of secular rising commodity prices, eliminates volatility and trend movements, our measure only eliminates volatility. 

Bandholz's volatility-weighted measure has yet to be adapted to core PCE deflator - the Fed's inflation gauge of choice. For now, the volatility-weighted CPI seems a better predictor of future headline CPI inflation - exhibiting higher correlation and lower average deviation - than core CPI.

As of June, the volatility-weighted measure of inflation stands at 3% y/y, well over the 2.2% recorded by core CPI: