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What is “core inflation,” and why do economists use it instead of overall or general inflation to track changes in the overall price level?
There are two measures of inflation : Headline Inflation and Core Inflation.
First let us understand inflation in simple terms.
What is inflation?
“In 1947, a 10 gram gold coin would cost Rs. 88.” There are many other stories about how cheap things were in 1947 at the time of independence in India. Today, a 10 gram Gold Coin would cost around Rs. 50,000, a roughly 570 times increase over its 1947 price. The overall rise in prices is known to economists as inflation.
In the long run, inflation is caused by too much growth in the money supply. In macroeconomics, the money supply refers to the total volume of money held by the public at a particular point in time in an economy. Monetary inflation obscures the price signals that make our market system work efficiently. The job of monetary policy (and central banks) is to supply just the right amount of money so that the average price level remains stable.
The question is, what is the correct measure of inflation and why are there two measures of inflation?
Headline inflation refers to the change in value of all goods in the basket. Core inflation on the other hand excludes food and fuel items from headline inflation.
Core Inflation = Headline Inflation – Food Inflation – Fuel Inflation
The maintenance of price stability—avoiding high inflation rates or deflation over time—is important for central banks because fluctuating prices distort the economy’s price signals and can result in the misallocation of resources.
The central bank reviews and analyzes the available inflation measures to monitor how well it is achieving its price stability goal.
One common way economists at central bank use inflation data is by looking at “core inflation,”. It is generally the a chosen measure of inflation (e.g., the Consumer Price Index or CPI, the Personal Consumption Expenditures Price Index or PCEPI, or the Gross Domestic Product Deflator) that excludes the more volatile categories of food and energy prices.
Why are food and energy prices excluded from inflation measure? Why are they more volatile than other prices?
Food and energy are more sensitive to price changes. The reason is that there are several variables such as environmental factors that can ravage a year’s crops. Similarly oil supply from OPEC is volatile and subject to geopolitical short term shocks. Each of these is an example of a supply shock that may affect the prices for that product.
The prices of food and energy ( and their related goods) may frequently increase or decrease at rapid rates. However, the price disturbances may not be related to a trend change in the economy’s overall price level. Instead, changes in food and energy prices often are more likely temporary and often reverse themselves without monetary intervention.
To demonstrate just how volatile energy prices, for example, can be relative to other prices less food and energy, the following chart compares the fluctuations of these two measures over time.
Fluctuations in energy prices are illustrated by the red line, while a trend increase in general prices is represented by the less volatile blue line.
When the price of oil, an important input of many other goods, increases it will make oil-dependent goods and services (e.g., automobiles) more expensive relative to less oil-intensive goods and services (e.g., computers).
Should food and energy prices ever be included in measures of inflation?
If economists were to look only at measures of inflation that include expenditures on food and energy, they may take incorrect actions and divert resources wrongly. This is because food and oil rise more rapidly than other things in inflation basket. An additional argument for excluding changes in food and energy prices from measures of inflation is that, “although these prices have substantial effects on the overall index, they often are quickly reversed and so do not require a monetary policy response.”
In general, headline inflation is more relevant for developing economies such as India, as it accounts for a greater share (30-40%) of household expenditure in comparison to developed economies (10-15% of household expenditure)