Blog - Investing Notes

July 17, 2007 - Responding to Energy Price Inflation at the Federal Reserve

Our Real Earnings Yield Model comes in two flavors, one that uses total inflation and one that uses core inflation to specify the "correct" aggregate stock market earnings yield. What are the implications of strong energy price inflation for these model alternatives? In their July 2007 paper entitled "Taylor Rules with Headline Inflation: A Bad Idea", Rajeev Dhawan and Karsten Jeske examine how central bankers should respond to energy price inflation in setting interest rates. Specifically, they test a modeled economy's behavior when a central bank following a Taylor rule (interest rate response rule) faces a doubling of energy prices. Using a complex rational expectations model, they conclude that:

• While the central bank cannot completely shield the economy from an energy price spike, a monetary policy that responds to core inflation does better than one that responds to headline (total) inflation.
• The less weight given to energy inflation, the lower the impact of an energy price shock on GDP and subsequent inflation. In fact, the central bank can lessen the impact of such a shock by assigning a negative weight to energy inflation, so long as it remains vigilant on core inflation.
• Rebalancing between durable goods and fixed capital investment is key in explaining this unconventional wisdom.
• Results vindicate the claim of Bernanke, Gertler and Watson (1997) that a less aggressive response by the Federal Reserve to the energy price increases of the 1970s would have stabilized inflation without harming economic growth.

The following chart, excerpted from the paper, summarizes the impacts of a doubling in energy prices on modeled core inflation and modeled federal funds rate for alternative central bank response rules. The horizontal axis is in quarters. Results indicate that accommodating, rather than fighting, energy inflation (Rule 3) implies the smallest response for the Federal Funds Rate and the most benign outcome for future core inflation. See the paper for discussion of the other rules.

In summary, this model indicates that the Federal Reserve should (and will?) accommodate, not fight, energy price inflation.

The aggregate S&P 500 earnings yield tracks total inflation better over the long term (1990-present), but core inflation better over the short term (last three years). Perhaps investors are now strongly in alignment with the Federal Reserve on core inflation as the essential wealth discount rate.

For related discussions, see the REY Model and Blog Synthesis: The Economy and the Stock Market.