Core inflation

Consumer Price Index (CPI)

  CPI

  Core CPI

Core inflation represents the long-run trend in the price level. Measurements of long-run inflation should exclude transitory price changes. One way of accomplishing this is by excluding items frequently subject to volatile prices, like food and energy.

History

The concept of core inflation as aggregate price growth excluding food and energy was introduced in a 1975 paper by Robert J. Gordon. This is the definition of "core inflation" most used for political purposes. The core inflation model was subsequently developed and advocated by Otto Eckstein, in a paper published in 1981. According to the economic theory historian Mark A. Wynne, "Eckstein was the first to propose a formal definition of core inflation, as the 'trend rate of increase of the price of aggregate supply.'”

Usage

The preferred measure by the Federal Reserve of core inflation in the United States is the change in the core personal consumption expenditures price index (PCE). This index is based on a dynamic consumption basket. Economic variables adjusted by this price deflator are expressed in chained dollars, rather than the alternative constant-dollar measure based on a fixed goods' basket.

Since February 2000, the Federal Reserve Board’s semiannual monetary policy reports to Congress have described the Board’s outlook for inflation in terms of the PCE. Prior to that, the inflation outlook was presented in terms of the CPI. In explaining its preference for the PCE, the Board stated:

The chain-type price PCE index draws extensively on data from the consumer price index but, while not entirely free of measurement problems, has several advantages relative to the CPI. The PCE chain-type index is constructed from a formula that reflects the changing composition of spending and thereby avoids some of the upward bias associated with the fixed-weight nature of the CPI. In addition, the weights are based on a more comprehensive measure of expenditures. Finally, historical data used in the PCE price index can be revised to account for newly available information and for improvements in measurement techniques, including those that affect source data from the CPI; the result is a more consistent series over time.

—Monetary Policy Report to the Congress, Federal Reserve Board of Governors, Feb. 17, 2000

Previously the Federal Reserve had used the US Consumer Price Index as its preferred measure of inflation. The CPI is still used for many purposes, for example, for indexing social security. The equivalent of the CPI is also commonly used by central banks of other countries when measuring inflation. The CPI is presented monthly in the US by the Bureau of Labor Statistics. This index tends to change more on a month-to-month basis than does "core inflation". This is because core inflation eliminates products that can have temporary price shocks (i.e. energy, food products). Core inflation is thus intended to be an indicator and predictor of underlying long-term inflation.

Several central banks also utilize core inflation as their primary target from the perceived impact of monetary policy to influence economic demand. This is due to the overall headline inflation including volatile commodity items wherein short-term seasonal price fluctuations cannot be sufficiently addressed through monetary policy alone, and may require non-monetary interventions such as price controls, addressing supply chain bottlenecks, or other forms of fiscal policies.

In 2006, an analysis by the Federal Reserve Bank of New York indicated that as a measure, core inflation was no better than a moving average of the Consumer Price Index or CPI as a predictor of inflation.

Approaches to core inflation

Core inflation can be computed using various approaches in order to capture underlying inflationary pressures. Every country maintains its own approach of determining the official core inflation figure. Typically, core inflation is provided as complementary to the overall headline inflation by national statistical agencies. Central banks, at times, calculate core inflation outside of the official figure by statistical agencies to enable them to determine specific sources of inflationary pressures.

Exclusion-based methods

This approach is the most common method of determining core inflation adopted by various countries and central banks, which involves computing a separate index by removing a pre-determined set of volatile items (typically food and energy items) from the overall headline inflation. These policy-setting bodies broadly cited ease of understanding by the public for utilizing this approach in reporting official core inflation compared to other approaches. Some countries also consider removing items which can be indirectly influenced by monetary policy, such as the United Kingdom's RPIX, which excludes mortgage interest payments from the headline Retail Price Index (RPI) figure.

While seen as the simplest method in computing core inflation, exclusion-based methods can mask structural changes in inflation dynamics driven by shifts in fiscal policies, such as price regulations on less volatile items, price subsidies, tax policies, among others.

Trimmed mean

See also: Trimmed estimator

A trimmed mean core inflation, which separates "noise" and "signal" means that the highest rises and declines in prices are trimmed by a certain percentage, attributing to a more accurate measurement on core inflation. In the United States, the Dallas Federal Reserve computes trimming at 19.4% at the lower tail end and 25.4% at the upper tail. The Bank of Canada use 20% trim for both the lower and upper tail ends.

Weighted median

The median inflation is derived from arranging the changes in price levels at specific item level specifications, then the cumulative weight influence is computed wherein the price change exactly located at the 50th percentile is reported as median core inflation. In the US, the median core inflation is usually higher than the trimmed core inflation figures (both PCE and CPI). The Cleveland Federal Reserve computes a Median CPI and a 16% trimmed mean CPI. There also is a median PCE, but it is not widely used as a predictor of inflation.

Trimmed mean and median inflation offer formal approaches of stripping out commodity items which exhibit significant price movements on a regular basis, in contrast to the exclusion-based approach which fixes the excluded items in its calculation. However, its more rigorous methodology and the constant shifting of excluded items are seen to potentially cause confusion to the public, especially in high inflationary environments. This phenomenon while using more formal approaches can likewise confuse policymakers in identifying persistent sources of price pressures.

Econometric-based models

Some central banks utilize econometric-based approaches to core inflation which considers historical patterns of price behaviors and attempt to explain current price movements with the aid of statistical techniques, such as regression analysis. The Bank of Canada uses an approach based on the common component, called "CPI-common" in its set of core inflation figures. However, its less intuitive nature limits its use to economists and experts. This approach can also become prone to substantial revisions as unusual economic behaviors or disruptions (e.g. the COVID-19 pandemic) might warrant changes in the assumptions used for this approach. The Bank of Canada likewise advised the public that "caution is necessary when interpreting real-time estimates of CPI-common in the current environment [i.e. pandemic]."

See also

• Headline inflation
• Inflationism
• Inflation hedge

External links

• Core Inflation: A Review of Some Conceptual Issues, Mark A.Wynne, Federal Reserve Bank of St. Louis Review, May/June 2008
• OECD inflation statistics
• Core Logic, Paul Krugman, February 26, 2010 – explanation of concept and motivation