Core Inflation

Core inflation seeks to measure the underlying, or core, inflation, the persistent trend in the inflation numbers. The concept of core inflation addresses the problem of uncovering which price increases are permanent and which are transient. Put differently, core inflation aims to be a better predictor of the future inflation rate than the actual inflation rate. The most common measure of core inflation equals the growth rate of the Consumer Price Index or Personal Consumption Expenditure Index after the food and energy components have been subtracted. As use of the concept of core inflation has spread, the term “headline inflation” has come to refer to the actual inflation rate. Advocates of the concept of core inflation claim it more effectively signals what the headline inflation rate will be in the medium to long term, and that the long-term average of the more volatile headline inflation rate will roughly equal the core inflation rate.

The CPI index for 2005 shows that headline inflation in the United States registered 3.5 percent, whereas core inflation posted a mere 2.1 percent. The tendency of the core inflation rate to mirror long-term trends shows up when inflation rates are averaged over longer spans of time. Between 1996 and 2004, headline CPI inflation in the United States averaged 2.42 percent, whereas core CPI inflation measured 2.23 percent.

The idea is that food and energy prices are more volatile. Over time, changes in the prices of these commodities either subside or work their way into core inflation. Food and energy prices are volatile because supplies are exposed to onetime shocks. In the case of food, a onetime shock could take the form of drought or pestilence. In the case of energy, high concentration of world crude oil reserves in politically volatile areas lead to onetime interruptions in supply.

The concept of core inflation rarely came up in economic discussions before the 1970s. The Economic Report of the President (1971) advanced the concept of the CPI less mortgage interest and food prices, but the term “core inflation” was not mentioned. The idea of removing mortgage interest did not become part of the concept of core inflation. After the mid-1970s, the term “core inflation” came into use and economists subjected the concept to systematic and rigorous analysis. In 1978, the Bureau of Labor Statistics began reporting versions of both the CPI and the Producer Price Index that excluded food and energy. In 1981, wellknown economist Otto Eckstein published the book Core Inflation. Eckstein defined core inflation in terms of weighted growth in unit labor and capital costs, but the concept of core inflation remained largely associated with measures of inflation that excluded food and energy.

Economists have questioned whether the exclusion of food and energy gives the best measure of core inflation. One possibility for calculating core inflation involves subjecting inflation series to a time-series smoothing process that spreads over time the effects of volatile components. Another possibility involves the calculation of a weighted median inflation rate. The weighted median inflation rate is the inflation rate for a chosen product. The chosen product is the one for which half of expenditures go to pay for products whose prices are rising just as fast or faster, and half of expenditures go to pay for products whose prices are rising just as slowly or more slowly. The chosen product exhibits the median inflation rate. Studies suggest that other measures of core inflation work just as well in forecasting inflation.

The practice of excluding food and energy from inflation measures draws criticism from observers who cite the importance of food and energy in the cost of living for wage earners. For this reason, other measures of core inflation may eventually displace the familiar measure based on the exclusion of food and energy.