 Ask
Dr. Econ
October 2004
What is "core inflation," and why do economists use it instead
of overall or general inflation to track changes in the overall price
level?
The question of the correct way to measure inflation is an important
one. Price stability over time, along with "maximum" sustainable
economic output and employment, are the Federal Reserve's primary goals
in making monetary policy. The maintenance of price stability—avoiding high inflation
rates or deflation over time—is important because fluctuating prices
distort the economy’s price signals and can result in the misallocation
of resources. 1
The Federal Reserve carefully reviews and analyzes the available inflation
measures to monitor how well it is achieving its price stability goal.
One common way economists use inflation data is by looking at “core
inflation,” which is generally defined as 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 typically more volatile than other prices?
To understand why the categories of food and energy are more sensitive
to price changes, consider environmental factors that can ravage a year’s
crops, or fluctuations in the oil supply from the OPEC cartel. Each is
an example of a supply shock that may affect the prices for that product.
However, although the prices of those goods may frequently increase or
decrease at rapid rates, 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 related to temporary
factors that may reverse themselves later.
To demonstrate just how volatile energy prices, for example, can be
relative to other prices less food and energy, Chart 1 compares the fluctuations
of these two measures over time.
Chart 1
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. 2
Fluctuations in energy prices reflect a change in those prices over
time relative to other prices. This means, for example, that increases
in the price of oil, an important input of many other goods, will make
oil-dependent goods and services (e.g., automobiles) more expensive relative
to less oil-intensive goods and services (e.g., bicycles). The important
point to note is that the energy price fluctuations displayed by the
red line in Chart 1 often resulted from factors other than an underlying
trend increase in general prices (the blue line). Therefore, the changes
in energy prices are not necessarily a sign of inflation and, when they
are included, can distort a trend increase in general prices. By measuring
core inflation, economists are attempting to isolate what is happening
to general prices without distraction from spikes in volatile energy
prices. 3
The PCEPI is another popular measure of inflation. This measure is based
on Personal Consumption Expenditures (PCE), which is the component of
GDP that includes all consumer spending on durable goods, nondurable
goods, and services. To illustrate the important difference between PCE
and “core” PCE, the two inflation measures are displayed
in Chart 2.
Chart 2
As you can see, the red line shows a bit more fluctuation than the blue
line. In other words, leaving out the volatile categories of food and
energy yields a more steady measure of inflation, and thus is more likely
to reflect the overall trend change in the economy’s general price
level.
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, which would include their more-sensitive
price fluctuations, they may be fooled into believing that general prices
are rising or falling more rapidly than they really are. 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.” (Motley, 1997)
Having said this, measures of inflation that do incorporate food and
energy prices are still useful in many circumstances and are closely
followed by economists for clues to the behavior of the overall price
level. For example, economists may view the sensitive nature of food
and energy prices as a symptom of future overall price increases. “A
rise in aggregate demand that might set off a period of higher inflation
may initially show up in increases in certain sensitive prices that are
set in more competitive markets. If these prices are ignored because
they are ‘volatile,’ these early signals of inflation may
be missed.” (Motley, 1997).
Determining when to use a core inflation measure versus an overall inflation
measure can be a very complicated question. For more information on when
and why more inclusive measures of inflation might be useful, please
see the San Francisco Federal Reserve’s April 18, 1997 Economic
Letter and Gavin and Mandal (2002). 4
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