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What is core inflation?

Some economists prefer using core inflation when evaluating the level of price growth in an economy. But what does core inflation mean? Here we take a look at a detailed core inflation definition. 

What is core inflation?

Core inflation is the change in the prices of goods and services in a country over a period of time. It excludes food and energy prices. Core inflation can be measured in two ways: 

  • Core Consumer Price Index (CPI)

  • Core Personal Consumption Expenditures (PCE) 

Each month, the US Bureau of Labor Statistics (BLS) calculates and publishes CPI data, and the country’s Bureau of Economic Analysis (BEA) releases the PCE price index. They publish data on consumer price indices for the US and several other geographic areas.

According to the BLS, the definition of CPI is as follows:

“A measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” 

The BEA defines the PCE price index as:

“A measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services. The PCE price index is known for capturing inflation (or deflation) across a wide range of consumer expenses and reflecting changes in consumer behaviour.”

To deduce the core inflation rate, both the BLS and BEA exclude the cost of food and energy. So, the definition of core inflation is the level of price growth for goods and services, without food and fuel prices.

Key points

  • Core inflation strips out price changes for food and fuel, due to their volatility.

  • The Core Consumer Price Index (CPI) and Core Personal Consumption Expenditure are the key readings for core inflation.

  • Core inflation can indicate what inflation looks like once volatility normalises. 

  • However, rising energy prices can increase the cost of other goods.

  • Core inflation metrics should be used with other indicators such as headline inflation, producer price indices (PPI) and others.

Headline inflation vs core inflation explained

Core CPI inflation is simply the exclusion of the changes in food and energy prices from the headline CPI inflation. Similarly, Core PCE strips out food and fuel prices from the overall PCE. 

Why are food and energy excluded?

Changes in food and energy prices are excluded from core inflation because of their volatility, which can skew the reading. 

Food and energy are staple products with price-elastic demand. In other words, consumers would still buy these products if the price increases, as staples are essential for living. 

Energy also includes commodities such as oil and gas, which are traded on exchanges. Shifts in investor sentiment about the supply and demand of oil and gas may affect commodity prices. 

For example, investors may speculate on an impending war and foresee a crunch in the supply of oil. In such a scenario, the price of oil would rise in anticipation of lower supply. 

Or, investors may speculate on an global recession, which would hit demand and push oil prices down.

Food includes agricultural commodities such as corn, soya beans, rice and oats, which can be purchased and sold on exchanges. Investor sentiment on food commodity prices can lead to price volatility. 

In addition, extreme changes in weather conditions, such as floods, cyclones or droughts, may affect the prices of agricultural commodities as they influence supply. This, in turn, would have an effect on food production and lead to changes in the price of food. 

How is core inflation calculated?

One may calculate core inflation by using this formula:

CI= Psg– Pef

where
CI = core inflation;
Psg = change in prices of goods and services
Pef = change in prices of energy and food

Why is core inflation rate important?

By stripping out the volatility of food and energy, core inflation may offer a more balanced view on the underlying level of price growth in an economy. 

The difference between core and headline inflation readings also shows to what extent inflation is driven by rising food and fuel prices. Core inflation can indicate what the price growth would look like once volatility normalises. Daniela Hathorn, market analyst at Capital.com explains:

“A generalised increase in core CPI will let policymakers know that monetary policy is likely too accommodative and the economy is at risk of overheating, which could cause more damage if left unchecked. The inverse is also true, and falling CPI may signal that consumers are struggling to spend because of elevated borrowing costs or financing conditions.”

Limitations of core inflation

The key criticism of excessive focus on core inflation is that rising energy prices typically boost the cost of other goods, as energy is needed for their production. Overdependence on core inflation readings may lead policymakers, such as central banks, to ignore the primary drivers of inflation. 

Capital.com’s Daniela explained that core inflation “also fails to identify the cause behind price increases, which can include innovation and improvements, and also fails to identify price increases per unit, given how businesses can keep prices unchanged but deliver less product”.

Therefore, to accurately estimate the level of price growth in an economy, policymakers use other indicators alongside the core inflation example such as producer price indices (PPI). Daniela added:

“PPI is one example, and a very important, because it measures the change in prices at the beginning of the production line, something that may very well end up trickling down to consumers if businesses don't swallow up the costs.”

FAQs

What is the difference between inflation and core inflation?

The key difference is that core inflation strips away the changes in prices of food and energy due to their volatility. Therefore, if inflation is mainly driven by these components, core inflation reading would be lower than the headline inflation. 

How do you calculate core inflation rate?

One may calculate core inflation by using this formula: CI= Psg– Pef, where CI = core inflation; Psg = change in prices of goods and services; Pef = change in prices of energy and food.

What items are included in core inflation?

Core Consumer Price index (CPI) inflation includes the prices of all items cotained by the consumer basket of goods, excluding food and energy items. 

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