Core inflation

Core inflation is a more reliable indicator of inflationary pressures in a country’s economy. Traders and investors closely monitor core inflation data since it provides information on the state of the economy as a whole and possible future central bank monetary policy choices.

Table of Contents

What is core inflation?
Understanding core inflation
Uses of core inflation
Calculation of core inflation
Examples of core inflation
Frequently Asked Questions

What is core inflation?

The term “core inflation” defines the underlying trajectory of inflation, which does not include the fluctuating prices of core goods such as food and energy. It is a figure for the success of monetary policy measures because they affect core inflation levels more than non-core or food inflation.

Higher interest rates and tighter monetary policy may impact investment decisions if the core inflation rate is higher than projected. On the other hand, less-than-expected core inflation may indicate signs of an economic slowdown, which would affect market forecasts and asset allocation.

Understanding core inflation

To fully understand core inflation, one must analyse the fundamental causes of rising prices in an economy, eliminating volatile aspects like the cost of food and energy. Decisions made by economists and policymakers are more accurate when they have a clearer understanding of long-term pricing trends due to core inflation.

Core inflation is measured by both the consumer price index (CPI) and the core personal consumption expenditures (PCE) index. The PCE represents the cost of goods and services consumers purchase in the U.S.

With a firmer grasp of core inflation, traders can predict central bank activities and modify their investment strategy. For example, investors may anticipate stronger monetary policy and higher interest rates in response to growing core inflation, which can impact bond yields and market values.

On the other hand, a core inflation rate that is low or dropping might lead to an accommodating monetary policy that would encourage economic expansion and boost stock values. To navigate financial markets efficiently and maximise investment returns, traders and investors must understand fundamental inflation dynamics.

Uses of core inflation

Determining when to use an overall inflation metric versus a core inflation measure might be difficult. Some of the primary uses of core inflation include:

Central banks prefer to use the core inflation rate when setting monetary policy because it is much more accurate than the headline inflation rate.
Core inflation determines the effect of increasing prices on consumer income.
Core inflation helps monetary authorities separate short-run fluctuations from more persistent trends.
Core inflation data can impact market expectations about future changes in interest rates, which can impact bond yields, stock prices, and exchange rates.

Calculation of core inflation

The formula for calculating core inflation is: 

CI = change in the price of all goods and services (Psg) – change in the price of energy and food (Pef) 

Or;

CI= P– P 

The core inflation rate is more accurate than the headline inflation rate in measuring underlying inflation trends. This is because energy and food prices are unpredictable and change so quickly that including these categories can cut an accurate reading of the actual severity of inflation. 

Other methods of calculating core inflation include:

Regularly excluding certain components.
Case-by-case specific adjustment of prices.
Using some statistical criteria.
The outliers method removes the products with the most significant price changes.

Examples of core inflation

Imagine a situation where the country’s energy costs unexpectedly rise as a result of geopolitical unrest. As a result, the headline inflation rate increases dramatically, alarming the public and politicians. However, further investigation reveals that the increase in energy costs is only temporary and has barely anything to do with the economy’s underlying inflationary forces.

In this case, the underlying inflationary trend is better reflected by core inflation, which does not account for fluctuating energy prices. Even while headline inflation could see a brief spike, core inflation stays consistent, suggesting that an energy price shock doesn’t significantly influence the economy’s overall price level.

This enables policymakers to keep monetary policy stable and avoid overreacting to brief variations in headline inflation. Given that the energy price rise was only temporary, traders and investors should prioritize core inflation statistical analysis when evaluating the long-term prospects of the financial markets and the economy.

Frequently Asked Questions

What is the concept of core inflation?

Core inflation, a measure of inflation that eliminates volatile price components like food and energy, can provide a more consistent prediction of fundamental inflationary dynamics. It supports decision-making on monetary policy and macroeconomic perspectives by assisting analysts and policymakers in determining the real inflationary trend.

What is the difference between CPI and core inflation?

The Consumer Price Index (CPI) reflects the average fluctuation in prices that customers pay for various products and services, such as food and energy. On the other hand, core inflation is a metric that only accounts for changes in the prices of different products and services, eliminating the cost of energy and food.

While CPI gives policymakers and analysts a broad picture of price swings that impact consumers, core inflation offers a more focused view by eliminating the often volatile food and energy costs. This gives policymakers and analysts a more precise picture of the underlying inflation trend.

What is the difference between PCE and core inflation?

The personal consumption expenditures (PCE) index tracks variations in household purchases of goods and services, such as food and energy. However, core inflation provides a more consistent indicator of underlying inflation trends by excluding volatile components, such as food and energy, from the inflation computation.

Core inflation only considers the persistent price rise, whereas PCE incorporates variations in consumer spending overall.

What are the three types of inflation?

There are three primary types of inflation:

Demand-pull inflation
Cost-push inflation
Built-in inflation

What is the difference between headline and core inflation?

Headline inflation is prone to short-term swings brought on by volatile elements such as food and energy costs since it considers all commodities and services in its computation. As a more consistent indicator of underlying inflationary trends, core inflation, on the other hand, does not include these erratic components.