What Is Core Inflation?
Core inflation is the change in the costs of goods and services, but it does not include those from the food and energy sectors. This measure of inflation excludes these items because their prices are much more volatile. It is most often calculated using the consumer price index (CPI), which is a measure of prices for goods and services.
Understanding Core Inflation
Core inflation is measured by both the CPI and the core personal consumption expenditures index (PCE). The PCE represents the prices of goods and services purchased by consumers in the U.S. Since inflation is a measure of the trend in rising prices, PCE is an important metric in determining inflation. However, core PCE and CPI are similar, and both help to determine how much inflation is in the economy.
Other methods of calculating core inflation include the outliers method, which removes the products that have had the largest price changes. Core inflation is considered an indicator of underlying long-term inflation.
- Core inflation is the change in the costs of goods and services but does not include those from the food and energy sectors.
- Food and energy prices are exempt from this calculation because their prices can be too volatile or fluctuate wildly.
- Core inflation is important because it's used to determine the impact of rising prices on consumer income.
Why Food and Energy Prices Are Excluded
Food and energy prices are exempt from this calculation because their prices can be too volatile or fluctuate wildly. Food and energy are staples, meaning demand for them doesn't change much even as prices rise. For example, gas prices may rise with the price of oil, but you will still need to fill up the tank to drive your car. Similarly, you won't be putting off buying your groceries just because prices are rising at the store.
Also, oil and gas are commodities and are traded on exchanges where traders can buy and sell them. Food, too, is traded including wheat, corn, and pork. The speculation of energy and food commodities leads to volatility in their prices, causing wild swings in the inflation figures. For example, a drought can cause dramatic effects on the prices of crops. The effects on inflation can be brief, meaning they ultimately correct themselves and the market returns to a balanced state. As a result, food and energy prices for these goods are excluded from the calculation of core inflation.
The Preferred Measure of Core Inflation
The Federal Reserve prefers to use the PCE index rather than CPI since PCE tends to provide inflation trends that are less affected by short-term price changes. Also, the Bureau of Economic Analysis (BEA), a division of the Department of Commerce, calculates the change of prices by using existing gross domestic product (GDP) data, which helps to determine an overall trend in prices. The GDP figure is a measure of the production of all goods and services in the U.S. The BEA also adds in the monthly Retail Survey data and compares them with the consumer prices provided by the CPI. These additions remove data irregularities and provide detailed long-term trends.
The Importance of Core Inflation
It is crucial to measure core inflation because it reflects the relationship between the price of goods and services and the level of consumer income. If prices for goods and services increase over time, but consumer income doesn't change, consumers will have less purchasing power. Inflation causes the value of money or income to decrease in comparison to the prices of basic goods and services.
However, if consumer income rises, called wage growth, while the prices of goods and services remain unchanged, consumers will have more purchasing power. Also, as investment portfolios and home prices rise, asset inflation occurs, which can provide additional money for consumers to spend.
What is purchasing power?
Purchasing power is the value of a currency expressed in terms of the number of goods or services that one unit of money can buy. Purchasing power is important because, all else being equal, inflation decreases the number of goods or services you would be able to purchase.
In investment terms, purchasing power is the dollar amount of credit available to a customer to buy additional securities against the existing marginable securities in the brokerage account. Purchasing power may also be known as a currency's buying power.
What is volatility?
Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security. Volatility is often measured as either the standard deviation or variance between returns from that same security or market index.
What is gross domestic product (GDP)?
Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country’s economic health.
Though GDP is typically calculated on an annual basis, it is sometimes calculated on a quarterly basis as well. In the U.S., for example, the government releases an annualized GDP estimate for each fiscal quarter and also for the calendar year. The individual data sets included in this report are given in real terms, so the data is adjusted for price changes and is, therefore, net of inflation.