FRBSF Economic Letter
2005-35; December 9, 2005
Shifting Data: A Challenge for Monetary Policymakers
A familiar old saw about the conduct of monetary
policy is that it's like trying to drive a car while looking
only in the rearview
mirror. The idea is that policymakers are trying to steer a course
that will keep the economy close to full employment with low,
stable inflation, while their only knowledge of the road ahead
is based on data about the past.
As if this situation weren't challenging enough, the rearview
mirror sometimes gives a distorted reflection, in the sense
that the data policymakers see at any one point in time are often
later revised. This Economic Letter discusses a particular
example,
the annual revision to the national accounts in July 2005,
which included a substantial upward revision to previously benign
inflation
estimates, and it lays out some ways that policymakers can
address the challenge of changing data.
How the national accounts
are produced and revised
The Bureau of Economic Analysis (BEA)
produces the national income and product accounts which include,
among other things,
quarterly
estimates of GDP and monthly estimates of price indexes
for personal consumption expenditures (PCE). Although the PCE
price index
is conceptually similar to the more widely known inflation
measure, the consumer price index (CPI), it differs in
a
number of technical
details. One difference is scope—the PCE index is a bit
broader than the CPI, in part because it includes more items
whose
prices are not observable and therefore must be imputed.
Another difference
is in the formulae—the PCE index uses so-called chain-weights,
which economists tend to prefer because the weights are
updated regularly to reflect actual spending patterns. Several
Federal
Reserve policymakers have indicated that they believe the
PCE index is a better gauge of inflationary pressures, and
typically
they prefer the "core" measure, which excludes
the volatile food and energy components (see, for example,
Yellen
2005).
In establishing a schedule of data releases, the
BEA can face some tension between timeliness and accuracy.
Often
the initial
releases are based on highly incomplete or even nonexistent
source data; later releases incorporate more complete
source data, some
of which (for example, tax data and many surveys) are
available only annually or even less often. Hence, over time,
the
BEA may revise earlier estimates to incorporate new source
data
and improved
methodologies. (See BEA 2004 for a discussion of methodology
and data sources.)
Some revisions are larger than others.
The most important are the annual revisions each July, when
the BEA revises
the most
recent three years of national income
and product data, and the so-called comprehensive or benchmark revisions,
which occur about every five years and which may involve
more major changes, for
example, in definitions, classifications, or presentation.
The
July 2005 annual revision
In the July 2005 annual revision,
the BEA revised its estimates of inflation and GDP for the
period 2002-2004.
Most notably,
the growth rate of core PCE
price inflation for 2004 was revised upward by about 0.6 percentage
point from a rate
of 1.6% to 2.2% (measured from the fourth quarter of 2003 through
the fourth quarter of 2004). There were also much smaller
revisions for 2002 and 2003.
Panel A of Figure 1 plots the 12-month change in core PCE price
inflation, both before
and after the annual revision. Panel B plots the 3-month change,
which shows that, despite the large upward revision to recent
history, inflation in the
second quarter of 2005 had receded somewhat from its earlier peaks.
The
bulk of the revisions to core PCE inflation occurred in its
so-called nonmarket component. The market component (accounting
for four-fifths
of all consumer
expenditure) covers items for which there are observable transactions
prices, such as purchasing
milk at a grocery store. The nonmarket component consists of
items
for which there are no observable transactions prices.
A good
example of a nonmarket component is a financial service that
commercial banks provide consumers, such as access to an
ATM network.
Bank depositors
often do not pay direct fees for a service like this, so there
is no observable transaction
price. Instead, depositors pay for such services by accepting
a lower return on their deposits. Banks can then use the funds
deposited
to buy interest-bearing
securities or to make loans—thereby earning income to cover
their costs of providing services to depositors. For each dollar
of deposits,
the
BEA in essence
counts
the margin between a "reference" (relatively risk-free)
interest rate and the rate paid to depositors as the nominal
output of the bank. The BEA uses
activity measures, such as ATM transactions and checks written,
to measure real output. Finally, the ratio of nominal to real
output measures the imputed price.
The majority of the July
2005 revisions in the nonmarket component occurred in two
categories: "services
furnished without payment by financial intermediaries except
life insurance carriers" and "medical care and
hospitalization insurance." The major contribution to
the first category, which accounted for about 1.6% of core
PCE, took place in the
category "other financial
institutions," which includes, for example, mutual funds.
Mutual fund expenditure, in nominal terms, basically involves
administrative expenses, such as researching
investments and managing accounts. The BEA measures real
mutual fund output mainly by the transactions that the funds
undertake;
the price deflator is then the
ratio of nominal expenditure to the index of real transactions.
Its deflator was revised up about 14 percentage points and,
as a result, this category contributed
about 0.23 percentage point to the upward revision in core
PCE inflation.
The second category, medical insurance, basically
involves the administrative costs paid by insurance companies.
This
is part
of what people pay
to consume medical services, but there are no directly
observable market prices for
these services. Instead, the BEA imputes a price for this
category. Medical
insurance
accounted for about 1.5% of core PCE in 2004. Its deflator
grew by about 9 percentage points faster over 2004 (Q4/Q4)
than previously
announced,
leading to a 0.14
percentage point increase to the revision in core PCE inflation.
In
both cases, the revisions reflected newly available source
data that indicated that the preliminary BEA estimates
were
inaccurate. We note
that both financial
and medical services raise considerable conceptual and
practical difficulties. Basu, Fernald, and Wang (2004),
for example,
discuss some of the conceptual
difficulties with financial-service measurement; for
services more
generally, it is difficult
to measure quality change over time. Nevertheless, these
difficulties are long-standing, and the revised data
presumably are more
comparable with
data for other time
periods and presumably give a more accurate read on where
the economy has been.
Implications for policy in 2004
When the Federal Open Market
Committee met in May 2004, the BEA's best estimate of core
PCE inflation was around
1-1/2%.
The statement
released
after the
meeting justified a "measured" pace of
adjustments to monetary policy by noting that inflation
was low: "…at
this juncture, with inflation low and resource use
slack, the Committee believes that policy accommodation
can be removed
at a pace that is likely to be measured."
The
revised figures indicate that core PCE inflation
was nearly 2-3/4% in the first quarter of 2004. How
might the
revised
information have
changed the course
of policy? One way to answer this question is to
invoke the Taylor rule. The FOMC does not set policy
according
to this
rule, but
the Taylor rule
has served
as a popular rule-of-thumb for how the Federal Reserve
might set its target for the federal funds rate.
The rule specifies
that
the Federal
Reserve's
target for the federal funds rate depends on (1)
an "inflation gap" that reflects
the difference between actual inflation and the Federal
Reserve's long-run objective, (2) an "output
gap" that reflects how far economic activity
is above or below its "full employment" level,
and (3) a "neutral rate" that
reflects the level of the short-term nominal interest
rate that would be consistent with full employment
and inflation at its objective.
Normally, the Taylor
rule is specified in terms of overall inflation,
not core inflation. Conceptually,
however,
since core inflation
was running higher than
the Committee thought, this suggests that there was
a larger positive "inflation
gap" than the Committee perceived. The Taylor
rule recommends responding to inflation more than
one-for-one. Hence, other things equal, given that
inflation
was running higher than originally thought, it would
have recommended a substantially higher setting for
the federal funds rate.
Conclusions
Yogi Berra once said, "It's hard to make predictions,
especially about the future." But it's also hard to predict
how our views of the past will change as statistical agencies
get new data and incorporate them into their estimates.
This Economic Letter focused on the recent revisions
to inflation figures, which suggest that inflation had been
running higher than previously reported. Such
uncertainty about the current state of the economy
complicates policymaking.
How can policymakers mitigate the
problems caused by inherently imperfect data? In assessing
underlying
inflationary trends,
policymakers can
look at a broader
range of inflation indicators as well as at
empirical relationships that might help predict inflation.
This
is the case even
if policymakers care
about an
inflation gap defined narrowly in terms of
core PCE inflation.
The problem of data uncertainty is, of course,
not limited to inflation. Policymakers also
need—but do not necessarily
have—timely
and
accurate measures of the
output gap (see, for example, Rudebusch, 2001,
and
Orphanides and Van Norden, 2002)
or the neutral rate of interest (see Laubach
and Williams, 2003, and Wu, 2005), two other
key components
for implementing
a Taylor-type
rule. These
concerns
again suggest looking broadly at indicators
of the economy, in line with Greenspan's (2005)
recommendation that policymakers
seek to
interpret "the full range
of economic and financial data."
John
Fernald
Vice President
Stephanie Wang
Research Associate
References
[URLs accessed December 2005.]
Basu, Susanto, John Fernald, and Christina Wang. 2004. "A
General-equilibrium Asset-pricing Approach to the Measurement
of Nominal and Real Bank Output." FRB Boston Working Paper 04-7.
Bureau of Economic Analysis. 2004. "Updated
Summary NIPA Methodologies."
Greenspan,
Alan. 2005. "Reflections
on Central Banking." Remarks
at a symposium sponsored by the Federal Reserve Bank of Kansas
City, Jackson Hole, Wyoming, August 26.
Laubach,
Thomas, and John C. Williams. 2003. "Measuring
the Natural Rate of Interest." Review of Economics
and Statistics 85(4), pp. 1063-1070.
http://www.federalreserve.gov/pubs/feds/2001/200156/200156abs.html
Orphanides,
Athanasios, and Simon Van Norden. 2002. "The
Unreliability of Output-Gap Estimates in Real Time." Review
of Economics and Statistics 84(4), pp. 569-583.
Rudebusch,
Glenn. 2001. "Is the Fed Too Timid? Monetary
Policy in an Uncertain World." Review of Economics
and Statistics 83(2), pp. 203-217.
Wu, Tao. 2005. "Estimating
the 'Neutral' Real Interest Rate in Real Time." FRBSF
Economic Letter 05-27 (October 21).
Yellen,
Janet. 2005. "Prospects for the U.S. Economy." Speech
to the Boalt Law School, University of California at
Berkeley, Berkeley, CA, March 2.
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
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