What Should the Federal Reserve Stabilize

Greg Mankiw writes:

Greg Mankiw's Blog: How should the Fed measure inflation?: If a central bank is to adopt inflation-targeting as a guide to policy, what inflation rate should it use? The Fed seems to focus on core PCE inflation--that is, inflation in the prices of consumer goods and services excluding certain volatile sectors, such as food and energy. From the standpoint of practical monetary policy, this choice seems sensible. But it is hard to square this common-sense decision with standard monetary theory, which doesn't readily yield a variable analogous to these empirical measures.

Steve Zeldes once observed that measures of core inflation are like the clues on the TV game show Jeopardy. The category is inflation. The answer is the CPI excluding food and energy. It is your job to figure out the question.

Some years ago, Ricardo Reis and I took a stab at this problem.... N. Gregory Mankiw and Ricardo Reis (2002), "What Measure of Inflation Should a Central Bank Target?" We developed a framework for thinking about the issue and applied it to U.S. data. We found that the price of labor (that is, the nominal wage) should be given substantial weight in the index used for monetary policy. But I will be the first to admit that this conclusion was too tentative to take to the (central) bank.

I (as I find myself doing so often these days) disagree with Greg Mankiw. The conclusions are tentative, yes, but they are very much worth taking to the (central) bank. The argument that central banks should focus mostly on stabilizing the growth rate of nominal wages is clear and convincing, as far as I know Mankiw-Reis is still state of the art, and it is an important and neglected problem that needs attention.