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Core inflation attempts to measure the rate at which the general price levels of goods and services is increasing. This is an important economic indicator because when general price levels increase, purchasing power falls. This situation translates into a lower standard of living as rapid increases in price levels mean that less goods and services can be bought for the same amount of money. Core inflation can be distinguished from headline inflation because the former excludes price increases in food and energy, while the latter includes these more volatile elements.
Food and energy prices are excluded from the calculation of core inflation because historically, these commodities have been subject to extremely unstable price changes. The unpredictable nature of food and energy prices can be attributed to the fact that the prices of these commodities are sensitive to variations in supply. The supply of food can be impacted by drastic weather conditions such as floods or drought, which in turn reduces the supply and causes steep price hikes. The supply of energy can be influenced by decisions taken by the Organization of Petroleum Exporting Countries (OPEC) cartel, which results in similar price increases. The calculation of core inflation therefore removes these volatile elements because the aim is to come up with a figure that represents real price increases, not price movements that are influenced by short term supply shocks.
Two measures are commonly used to find core inflation. To determine the core inflation of a country, either of these indices may be used with the effect of food and energy prices deducted from them. Both indices look at personal consumption, but there is an important difference between the two.
The Consumer Price Index (CPI) measures consumption based on the weighted average of a fixed basket of goods, which means that regardless of price increases of various goods, consumers are assumed to make the same choices. The Personal Consumption Expenditure (PCE) index recognizes that when prices change, consumers may adjust their spending to suit. For example, if meat prices increase too much, people may spend less on meat and more on vegetables; therefore, the PCE takes these changes into account.
Governments aim to control core inflation so that there is a more gradual increase in general price levels. This is the preferred state, as general price increases improve the likelihood that citizens can maintain a desired standard of living. The measurement of core inflation is also important for indicating the direction of real and potentially permanent price changes, which is used in the drafting of government policy. In essence, core inflation figures let governments know what areas of the economy demand attention and need program development to curb further price increases.