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IMF wants central bankers to focus on core inflation

A man takes a nap on sacks filled with onions at a wholesale vegetable market on the outskirts of Jammu on Wednesday. Indian headline inflation climbed to its highest in more than a year as prices of food and manufactured goods surged, reinforcing the case for another rate hike on Friday despite weakening growth and a worsening global outlook.


You can probably add the International Monetary Fund to the camp that feels the European Central Bank shouldn't have raised interest rates in July.

At the time, high energy and food costs were pushing up wages and other prices in healthy economies like Germany, even though it already seemed clear that tighter borrowing conditions were the last thing the euro zone's more fragile, heavily indebted nations needed. Jean-Claude Trichet, the ECB president who retires next month, judged inflation risks were paramount and raised his benchmark interest rate by 25 basis points, to 1.5 per cent, a move many say exacerbated the debt crisis.

The IMF hasn't come out and criticized Mr. Trichet explicitly.

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But in an analysis of how central banks ought to control the cost of living, the Washington-based lender suggests policy makers might be better off focusing on ``underlying inflation'' -- i.e. inflation measures that strip out volatile items like the food and gas prices that were soaring earlier this year. Doing so would reflect price trends that are ``likely to be sustained over the medium term,'' the IMF says.

The IMF's analysis -- released Wednesday in a chapter of its World Economic Outlook -- focused on developing countries, where food and energy make up much more of a typical family's budget. When central bankers in those countries target a measure of inflation that includes food and energy, the IMF says, policy makers are more likely to be off-target more often because they have little control over commodity-price shocks and, therefore, risk losing credibility.

Credibility and clear communication of policy goals are especially crucial for central banks in emerging markets where the track record in controlling inflation doesn't inspire as much confidence as in advanced economies. That's because if households and businesses fear inflation will keep rising, they may act in ways that ensures that this actually happens, or that otherwise crimp the economy.

But the general thrust of the IMF's analysis is also relevant to the advanced world, particularly the Frankfurt-based ECB, and critics of U.S. Federal Reserve Board Chairman Ben Bernanke.

The ECB has a somewhat vague ``goal'' of keeping annual inflation in the euro zone just under 2 per cent. That helps explain why Mr. Trichet was so concerned about runaway price gains when the ECB's so-called headline measure of inflation was spiking, as factors like the conflict in Libya and poor weather for farming pushed the cost of oil, agricultural staples and other commodities into the stratosphere. Now, though, as bond yields in many euro-zone nations continue to smash records and austerity measures strangle growth, the ECB is likely better off prioritizing the immediate threats to economic growth over the longer-term (and arguably more and more distant) threat of inflation spreading out of control.

Indeed, Mr. Trichet recognizes this; last week, he kept interest rates steady and left the door open for possible rate cuts as he presented a bleaker economic outlook.

The Fed, meanwhile, has no set target but attempts to keep annual inflation between 1.7 per cent and 2 per cent.

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Mr. Bernanke has kept rates near zero in the face of rising commodity prices, arguing they will prove to be temporary. His focus on underlying or ``core'' inflation has attracted criticism, but the Fed also has a mandate to foster ``maximum employment.'' With a jobless rate above 9 per cent, looking past higher food and energy costs is allowing Mr. Bernanke to keep policy looser for longer at a time when tighter conditions would be disastrous for the faltering U.S. economy.

And where does Bank of Canada Governor Mark Carney fit into all of this?

His central bank aims to achieve annual gains of 2 per cent in both headline and core inflation. But Canadian policy makers look to core inflation as their ``operational guide'' to broader, longer-lasting price trends. That gave Mr. Carney more leeway to ignore trigger-happy inflation hawks in the spring and summer, as they argued that the domestic economy had become too strong for near-emergency-low rates regardless of the external threats that were gathering.

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About the Author
Economics/business writer

Jeremy has covered Canadian and international economics at The Globe and Mail since late 2009. More

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