“Core inflation is considered an indicator of underlying long-term inflation”— Paul Ebeling
Core inflation is the change in the costs of goods and services but does not include those from the food and fuel sectors. This measure of inflation excludes these items because their prices are much more volatile. It is most often calculated using the consumer price index (CPI), which is a measure of prices for goods and services.
Core inflation is measured by both the CPI and the core personal consumption expenditures index (PCE). The PCE represents the prices of goods and services purchased by consumers in the US.
Since inflation is a measure of the trend in rising prices, PCE is an important metric in determining inflation. However, core PCE and CPI are similar, and both help to determine how much inflation is in the economy.
Other methods of calculating core inflation include the outliers method, which removes the products that have had the largest price changes.
Food and Fuel prices are exempt from this calculation because their prices can be too volatile or fluctuate wildly. Food and Fuel are necessary staples, meaning demand for them doesn’t change much even as prices rise.
For example, gasoline prices may rise with the price of Crude Oil, but you will still need to fill up the tank in order to drive your car. Similarly, you will not be pushing off buying your groceries just because prices are rising at the markets.
Also, Crude Oil, Nat Gas and gasoline are commodities traded on exchanges where traders can buy and sell them.
Food too is traded including wheat, corn, beef and pork.
The speculation of energy and food commodities leads to volatility in their prices, causing wild swings in the inflation figures. For example, a drought can cause dramatic effects on the prices of crops. The effects on inflation can be brief, meaning they ultimately correct themselves and the market returns to a balanced state. As a result, food and fuel prices for these goods are excluded from the calculation of core inflation.
The Fed prefers to use the PCE index rather than CPI since PCE tends to provide inflation trends that are less affected by short-term price changes. Also, the Bureau of Economic Analysis (BEA), a division of the Department of Commerce, calculates the change of prices by using existing gross domestic product (GDP) data, which helps to determine an overall trend in prices.
The GDP figure is a measure of the production of all goods and services in the US. The BEA also adds in the monthly Retail Survey data and compares them with the consumer prices provided by the CPI. These additions remove data irregularities and provide detailed long-term trends.
It is important to measure core inflation because it reflects the relationship between the price of goods and services and the level of consumer income.
If prices for goods and services increase over time, but consumer income does not change, consumers will have less purchasing power.
Inflation causes the value of money or income to decrease in comparison to the prices of basic goods and services.
But, if consumer income rises, called wage growth, while the prices of goods and services remain unchanged, consumers will have more purchasing power. Also, as investment portfolios and home prices rise, asset inflation occurs, which can provide additional money for consumers to spend.
Have a happy day, Keep the Faith!