The Economist

in its September 22, 2005 issue drew attention to the way inflation is
creeping up as a result of high energy prices, and questioned whether
the traditional definition of core inflation used by central banks
should be any longer acceptable.

In the 1970s, when oil prices rose sharply in
1973-74, it was decided to strip oil prices out of the CPI, so as not
to get a distorted measure of inflation. Then the US Federal Reserve
went to extremes as other items in the CPI regimen rose sharply in
price and they stripped a whole series of other items out of their
calculations. First food, then used cars, children’s toys, jewellery,
housing until around half the CPI basket needed to be excluded – a
custom which central banks around the world have followed.

Understandably, food prices are too volatile
with wide seasonal movements to be included in a non-distorted measure
of inflation. But energy costs are a different matter. With growing
evidence that there will be a peak in world oil supply over the next
five years, when oil demand will sharply exceed supply and prices
escalate sharply from current levels, it is foolhardy to exclude these
costs from any realistic measure of core inflation, particularly if a
central bank is aiming to target inflation in the setting of monetary
policy.

Read Ray Block’s full article here.

Peter Fray

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