Across the world, surging international food prices have become a major cause for concern and topic of debate. This is especially so in the Arab world, which is home to some of the largest food importers and where rising food prices have been one of the factors in recent political unrest.
In the context of ongoing political developments, governments across the region are responding to the rise in commodity prices with hikes in fuel and food subsidies, civil service wage and pension increases, additional cash transfers, tax reductions, and other spending increases. These measures will help poor households maintain their purchasing power and limit further increases in domestic food prices.
How should central banks -- whose task is to prevent general price increases that would further cut into peoples' incomes -- react? What inflation metric should they target?
Looking beneath the headlines
Economists often divide inflation numbers into headline inflation and core inflation.
Core inflation has been the yardstick by which many central banks -- especially in advanced economies where the weight of food and fuel in consumption baskets is relatively small -- make policy decisions. The idea is to keep the focus on longer-term trends to help avoid too-frequent changes in monetary policy and interest rates in response to temporary inflation shocks.
Across the Middle East and North Africa, headline inflation has accelerated over the last year, driven mainly -- as in other parts of the world -- by rising international commodity prices.
Core inflation in the region has exhibited a more modest upward trend than headline inflation over the last 12 months.
Getting an accurate picture
So, where food and fuel comprise such a large share in the consumption basket, a focus on movements in core inflation can provide a distorted picture of overall inflation trends in an economy. This can have the undesirable effect of underestimating inflation pressures, delaying needed monetary policy responses, and thereby increasing peoples' future inflation expectations.
Indeed, there are indications that food and fuel inflation are spilling over into core inflation by raising inflation expectations and boosting workers' demands for higher wages. For example, we calculate that in the Middle East and North Africa, about half of a shock to food inflation in any given quarter is transmitted to nonfood inflation in the following quarter of the year.
The upshot? Regional central banks cannot afford to cast aside headline inflation and focus only on core inflation when setting policy rates and the overall stance of monetary policy. They will need to focus on both in order to have a good sense of inflation developments, allowing them to be ready to react and contain inflation pressures as needed.
From iMFdirect blog