What is the Core Rate of Inflation?

Instructor: David Bartosiak

Dave draws off his years of experience as a Financial Advisor and Analyst to teach others all about finance and the investing world.

This lesson discusses the difference between core inflation and headline inflation. It also goes into detail on the different ways to measure inflation including the CPI and the PCE while relating core inflation to aggregate supply.

Finding Inflationary Trends

Inflation is one of the most important economic data points. Inflation data help economists understand how quickly prices are going up or going down in an economy. The Fed uses inflationary data to quantify the price-stability aspect of its dual mandate. There are a few different ways to measure inflation, with the Consumer Price Index being the most widely used by central banks around the world.

The Consumer Price Index (CPI) uses a broad basket of goods and services to determine price changes over time for out-of-pocket household expenses. This broad basket introduces volatility by having exposure to items such as food and energy. This added volatility has prompted some economists to use different measures of inflation.

By ignoring the more volatile parts of the inflationary basket, core inflation seeks to ignore transitory price changes and better show the actual long-term trend in prices. The problem with the more volatile parts of the inflation basket is that they can give false signals. If there is a short-term spike in food prices because of a drought that kills crops or another supply-side issue, this is something core inflation tries to ignore. Otherwise, economic forecasts would be based on short-term moves in price that are likely to work themselves out over the long run.

Core inflation is said to be a better predictor of long-term trends, while headline inflation data better represent the out-of-pocket expenses of consumers. Headline inflation data are the broad inflationary numbers that include food and energy. Core inflation data remove energy and food from the headline inflation data.

Global inflation rates in 2013

Getting to the Core

Changes in core inflation have an immediate impact on aggregate supply. An increase in the price paid causes increases in aggregate supply as producers increase supplies in order to grasp the inflated prices. Let's say XYZ Company is a widget maker. For the last year, XYZ has been producing widgets and selling them for the market price of $5. XYZ and all its competition in the widget industry make up the aggregate supply of widgets. If core inflation increases the price of these widgets to $5.50, the widget industry would ramp up production, making more and more widgets to capture the increased profit. This assumes the input costs of the widgets remain the same of course.

Here in the United States, core inflation is measured using the core Personal Consumption Expenditures Price Index. Similar to the Consumer Price Index, the Personal Consumption Expenditures Price Index (PCE) uses a weighted basket of goods and services to determine price changes over time on goods households and their agents spend money on.

The main differences between the PCE and CPI are the weighting of the basket and their perspective scopes. The PCE measures spending on behalf of the personal sector, including not only households, but also organizations, such as nonprofits, that spend on behalf of households. The CPI's scope is out-of-pocket spending only from households. In terms of the weighting, the PCE puts much less emphasis on housing and more emphasis on recreation than the CPI.

Core PCE data since 1959

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