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   c   u   r   r   e   n    t    i   s   s   u   e   s
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    V   o    l   u   m   e    1    9 ,    N   u   m    b   e   r    7
    2    0    1    3
    w   w   w .   n   e   w   y   o   r    k    f   e    d .   o   r   g    /   r   e   s   e   a   r   c    h    /   c   u   r   r   e   n   t_    i   s   s   u   e   s
The Parts Are More Than the Whole:Separating Goods and Servicesto Predict Core In
Richard Peach, Robert Rich, and M. Henry Linder 
 Economists have not been altogether successful in their e
orts to forecast “core” in
ation—an in
ation measure that typically excludes volatile food and energy prices. One possibleexplanation is that the models used to make these forecasts fail to distinguish the forces in
uencing price changes in coreservices from those a
ecting price changes in core goods.While core services in
ation depends on long-run in
ationexpectations and the degree of slack in the labor market, core goods in
ation depends on short-run in
ation expectationsand import prices. By using a composite model that combinesthese di
erent sets of explanatory variables, the authors of thisstudy are able to improve upon the in
ation forecasts produced by a standard model.
n its amendment to the Federal Reserve Act of 1913, the U.S. Congressdirected the Federal Reserve “to promote . . . the goals of maximumemployment, stable prices, and moderate long-term interest rates.”
 Because price stability—the second of these goals—is critical to achievingfull employment and low long-term interest rates, the Fed monitors in
ationcarefully. Indeed, Fed policymakers seek to forecast the path of in
ation oneto two years ahead—a strategy rooted in the knowledge that monetary policy actions a
ect the economy only with long and variable lags. Predicting thebehavior of in
ation over this extended time horizon, however, is easier said thandone, since in
ation tends to
uctuate markedly in response to external events.For this reason, policymakers have long been interested in identifying less volatilein
ation measures that provide a better guide to the
rate of in
ation.One approach has been the development of “core in
ation” measures—measuresthat either exclude the price changes of volatile items or include only a speci
csegment of the cross section of price changes. Among measures of core in
ation,the series excluding food and energy prices is probably the best-known example.
 Unfortunately, however, the models developed to forecast core in
ation—such asPhillips curve models—do not have a particularly good track record.
e Federal Reserve Reform Act of 1977, cited in Board of Governors of the Federal Reserve System,
e Federal Reserve System: Purposes and Functions
, 9th ed. Washington, D.C., June 2005, p. 15.
e measure of core in
ation excluding food and energy is published by the Bureau of LaborStatistics. Other well-known measures of core in
ation include the median and trimmed-mean.
Volume 19, Number 7 
One potential explanation for this weak performance isthat measures of core in
ation track a wide array of goods andservices whose prices change in response to di
erent factors.In this edition of 
Current Issues
, we explore this hypothesisby developing separate models for the core goods and coreservices components of the core consumer price index (CPI).
e evidence we present strongly suggests that the forcesin
uencing the rate of change for core services prices are quitedi
erent from those in
uencing the rate for core goods prices.In particular, while core services in
ation depends on long-run in
ation expectations and tightness or slack in the labormarket, core goods in
ation depends on short-run in
ationexpectations and import prices. We use the di
erent sets of explanatory variables to construct forecasts of overall coreCPI in
ation that combine the forecasts of these two models.While the analysis is preliminary, we
nd that our compositemodel yields forecasts that are markedly more accurate thanthose produced by a standard Phillips curve model, whichmakes no such di
Total CPI in
ation is quite volatile, owing in large part tosharp swings in food and energy prices (Chart 1). Very o
enthese swings have been driven by external events rather thandomestic economic conditions. While the Fed targets totalin
ation in seeking to meet the goal of price stability, analysts
nd it useful for policy purposes to monitor a measure of 
e Phillips curve model is a widely used tool for explaining and forecastingin
ation. It takes its name from the economist A. W. Phillips, who documentedthat nominal wages grow faster in periods when the unemployment rate islow. Subsequent work recast this relationship as one between price in
ationand unemployment. Modern Phillips curve models include a role for in
ationexpectations and a supply shock variable that captures the e
ects of externalfactors on the in
ation rate.
underlying in
ation that
lters out such volatility, such as theconventional core measure of in
ation that excludes food andenergy prices.
is core in
ation measure captures lower-frequency changes in the general price level and has alsoproved to be a more accurate predictor of total in
ation thanhas past total in
ation (Chart 2).Core in
ation can be broken out into two broad categories:core goods (commodities less food and energy commodities)and core services (services less energy services). Doing so, asshown in Chart 3, reveals two quite di
erent series. Not only do the absolute levels of the two series di
er but, over thepast decade, movements in the two in
ation rates have beeninversely correlated.
e divergent behavior of goods and services in
ationraises the possibility that their determinants may also di
er.To explore this idea further, we examine the relationshipover the period since 1985 between each of the in
ationseries shown in Chart 3 and two variables considered to beimportant components of Phillips curve models and otherempirical models of in
ation: long-run in
ation expectationsand an activity gap variable. Activity gap variables measureresource utilization, or the extent of slack in an economy.One widely used activity gap variable is the unemploymentgap—the di
erence between the actual unemployment rateand the Congressional Budget O
ce’s estimate of the levelof unemployment consistent with stable in
ation, known asthe NAIRU.
An unemployment rate above the NAIRU wouldindicate that the economy is operating with excess slack, andwould hence lead analysts to predict a decline in in
ation. Asecond activity gap variable is the output gap—the di
e acronym stands for “non-accelerating in
ation rate of unemployment.”
Chart 1
Consumer Price In
ation and Its Foodand Energy Components
Four-quarter percentage changeFour-quarter percentage change
Source: U.S. Bureau of Labor Statistics.Note:
is consumer price index.CPI: Energy ScaleCPI: FoodScaleTotal CPIScale
Chart 2
Consumer Price Index: Total versus Core In
Four-quarter percentage change
Source: U.S. Bureau of Labor Statistics.Note:
is consumer price index.-2-10123456Core CPITotal CPI2012201020082006200420022000
between actual GDP and the economy’s maximum sustainablelevel of output, or “potential GDP.” An output level below potential is another sign of excess slack in the economy, andwould also lead analysts to expect lower in
ation.To determine whether these variables do in fact help toexplain the two broad categories of core in
ation, we plot theprospective four-quarter-ahead in
ation rates (period
4) of core services and core goods, respectively, less ameasure of ten-year expected CPI in
ation (period
), againstthe current unemployment gap (period
For core services(Chart 4), the scatter plot provides evidence that an increasein the unemployment gap is associated with a decrease in thein
ation rate, although the relationship is nonlinear (that is,the decline in in
ation diminishes as the unemployment gapincreases). For core goods (Chart 5), the unemployment gapappears to play no role in the in
ation process. Taken together,these data suggest that the behavior and determinants of coreservices in
ation and core goods in
ation di
Previous Literature
Although the literature distinguishing core goods in
ationfrom core services in
ation is limited, we can draw uponsome earlier studies to motivate our analysis. In particular,these studies either assume that di
erent processes governthe movements in goods in
ation and services in
ationor identify di
erent determinants of the speed of priceadjustment for individual goods and services included inaggregate consumer price indexes.Peach, Rich, and Antoniades (1994) present a model-based analysis of the di
erence between goods in
ation andservices in
ation for the United States.
eir study estimates
Detailed information on the data series used in our analysis can be found inthe table on page 6.
a vector error correction model (VECM) for goods in
ationand services in
ation based on the
nding that a long-runrelationship exists between the series.
However, because
A principal feature of the model is that the two series do not deviate from eachother in the long run; in addition, the time paths of the series are in
uenced by the extent of any deviation from long-run equilibrium. See Enders (2004) for adiscussion of cointegration and vector error correction models.
Chart 3
ation Breakdown: Core Goods and Core Services
Four-quarter percentage change
-3-2-1012345Core goodsSource: U.S. Bureau of Labor Statistics.Core services2012201020082006200420022000
Chart 4
The Unemployment Gap and Adjusted CPI CoreServices In
ation: 1985-2012
Four-quarter-ahead adjusted CPI core services in
ation (percentage points)
Sources: U.S. Bureau of Economic Analysis; U.S. Bureau of Labor Statistics;Congressional Budget O
is consumer price index.-2-10123456-2.0-1.5-1.0-0.500. gap in quarter
(percentage points)
Chart 5
The Unemployment Gap and Adjusted CPI CoreGoods In
ation: 1985-2012
Four-quarter-ahead adjusted CPI core goods in
ation (percentage points)
Sources: U.S. Bureau of Economic Analysis; U.S. Bureau of Labor Statistics;Congressional Budget O
is consumer price index.-2-10123456-6-5-4-3-2-101Unemployment gap in quarter
(percentage points)

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