Core Inflation

Core inflation is the change in the costs of good services, but it does not include those from the food and energy sectors. This measure of inflation excludes these items because their prices are very volatile. 

Core inflation measures the change in average consumer prices after excluding from the CPI certain items with volatile price movements. By stripping out the volatile components of the CPI, core inflation allows us to see the broad underlying trend in consumer prices. Core inflation is often used as an indicator of  the long‐term inflation  trend  as  well  as  future  inflation.  The  long‐term  inflation  trend  is  primarily  affected  by  demand conditions which, in turn, can be influenced by monetary policy

Why do we need to measure core inflation?

Core inflation is an indicator of the underlying movement in consumer prices since it takes out the effect of temporary disturbances and shocks that cause prices to surge or decline,  independent  of  economic  and  monetary  policy.  Measuring  core  inflation  helps  policymakers determine whether current movements in consumer prices represent short‐ lived disturbances or are part of a more permanent trend. Such knowledge is important in  the formulation of economic policy, particularly monetary policy, which responds mainly to  broad‐based pressures on prices. 

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.

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. 

What is included in Core Inflation

Core inflation is a form of a consumer price index (CPI) that covers changes in prices of all goods except food prices, fuel prices, income tax & financial investments in USA markets. However, as a general rule, the food and petroleum prices are exempted from calculating this inflation. Moreover, other than these two, all other goods and services that it includes are: Electronics, Real estate, Transport, Pharmacy, Retail, Aviation, Telecom, IT, etc.

Here is a core inflation example to explain the concept clearly. 

According to the Consumer Price Index for all urban consumers of the Fed, the USA had all-item CPI-based inflation of 5% in 2020. Moreover, according to the calculation, the food and petroleum sector’s inflation was 2%.

So, when the policymakers deducted the CPI from the foods & energy sector from the all item-based CPI, сore inflation was pegged at 3%. Usually, the inflation level must be around 2%. The Fed decided to put various balances and checks on the bank rates to reduce inflation. As a result, the Federal Open Market Committee (FOMC) got into action to increase the rate and decrease inflation to achieve the target of long-term core inflation of 2%.