The core inflation rate is synonymous to core CPI and Consumer Price Index (CPI) Less Food and Energy. This exclusion makes the core inflation rate more accurate than the headline inflation rate in measuring underlying inflation trends. This accuracy is why central banks prefer using the core inflation rate when setting monetary policy.
What Core Inflation Means for You
Although regular inflation—the increase of all items including food and energy products—could certainly have an impact on your day-to-day life by forcing you to tighten your budget, core inflation is the preferred indicator of inflation to the Federal Reserve. This means that, if the core inflation rate gets (and stays) too high, the Board of Governors of the Federal Reserve System will likely raise the federal funds rate, thereby increasing interest rates on mortgages, credit cards, and other consumer lending products. In other words, when the core inflation rate is elevated, not only will consumer items like housing, transportation, and clothing be more expensive, so too will the cost of borrowing money to purchase those items.
Why Food and Energy Prices Are Volatile
Food and energy prices are volatile because they are traded on the commodities market. Most food (like wheat, pork, and beef) and energy (oil, gas, and natural gas) are traded all day long. For example, commodities traders bid up oil prices if they suspect its supply will fall or demand will rise. They might think a war will dry up the supply of oil. They’ll buy oil at today’s price to sell at tomorrow’s higher anticipated price. That is enough to drive up oil prices. If the war doesn’t materialize, oil prices fall when they sell. Food prices rise along with gas prices because food is transported by interstate trucking. It consumes a lot of gas. When gas prices rise and stay high, you’ll eventually see its effect on food prices in a few weeks.
How the Fed Uses the Core Inflation Rate
The Fed’s mandate is to control inflation. While the Fed’s preferred measure of inflation is the Personal Consumption Expenditures (PCE) Price Index, the Fed also looks at the core inflation rate How does the fed funds rate affect inflation? If the fed funds rate increases, so will the rate for bank loans and adjustable-rate mortgages. As credit tightens, economic growth slows. As a result, companies must lower their prices to stay in business, and that reduces inflation. The Fed uses inflation-rate targeting. It would rather not take action if the core inflation rate is 2% lower than the previous year. What happens if the core inflation rate starts to creep above that inflation target and stays there? The Fed considers raising interest rates and other contractionary monetary policies. The Fed has to weigh this with its other mandate, encouraging economic growth and creating jobs. The chart below illustrates the U.S. core inflation rate from 1958 to the present. Specifically, it’s the year-over-year rate for each month. It measures how much prices, excluding food and energy, changed each month over a 12-month period.
How the Core Inflation Rate Is Calculated
The core inflation rate is measured by the core Consumer Price Index (CPI) and the core Personal Consumption Expenditures (PCE) price index. In January 2012, the Federal Reserve reported at its FOMC meeting that it preferred to use the PCE price index. The Bureau of Labor Statistics (BLS) reports the CPI. It surveys the prices of 80,000 consumer items to create the index. It collects this price information from thousands of retail and service companies. It chooses the types of businesses frequented by a sample of 14,500 families. As you can imagine, this takes some serious number-crunching, and it gives a pretty good indication of price changes. However, it is not as inclusive as the PCE price index. The PCE price index gives a better indication of underlying inflation trends than the core CPI. It’s less volatile, thanks to the way it’s measured. The BEA reports the PCE price index. The bureau measures price changes using gross domestic product (GDP) data. It then adds the monthly Retail Survey data, and adjusts them to consumer prices using the CPI itself. The BEA uses a different formula for the PCE to compute its estimates, which smooths out any data irregularities.
Why the Core Rate Is Critical
Inflation is when the prices of the goods and services you buy continue to go up over time. If your income doesn’t go up at the same rate, you lose buying power as prices rise. The only time inflation doesn’t weaken your standard of living is when it happens to your income. Inflation has a subtle yet destructive effect on economic growth. It’s subtle because you may only notice it over time if it’s only a 1% or 2% increase. It can have a bit of a positive effect at that rate. Economists theorize that consumers will stock up on goods now because they know the price will rise in the future. This increases demand, which stimulates economic growth. Over time, high inflation robs the economy of growth potential. If wages don’t keep up, then people are forced to spend more of their income on essentials, like food and gas, and less on other consumer products. Those other businesses become less profitable, and some will close down over time. That can lower the country’s economic output.
