Core inflation measures price increases of goods and services, excluding food and energy, which are volatile due to supply shocks. Two indices, CPI and PCE, are used to find core inflation, and governments aim to control it to maintain citizens’ standard of living and draft policies.
Core inflation attempts to measure how quickly the overall price levels of goods and services are rising. This is an important economic indicator because when general price levels rise, purchasing power falls. This situation results in a lower standard of living as rapid increases in price levels mean that fewer 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 for food and energy, while the latter includes these more volatile items.
Food and energy prices are excluded from the core inflation calculation because these products have historically been subject to extremely volatile price movements. The unpredictable nature of food and energy prices can be attributed to the fact that the prices of these products are sensitive to changes in supply. The food supply can be affected by drastic weather conditions such as floods or droughts, which in turn reduce the supply and cause sharp price increases. Energy supply can be affected by decisions made by the Organization of the Petroleum Exporting Countries (OPEC) Understanding, resulting in similar price increases. The core inflation calculation then removes these volatile elements because the goal is to come up with a figure that represents real price increases, not price movements influenced by short-term supply shocks.
Two measures are commonly used to find core inflation. To determine a country’s core inflation, one of these indices can be used with the effect of food and energy prices deducted from them. Both indices look at personal consumption, but there is one 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 no matter how much the prices of various goods increase, consumers are assumed to make the same choices. The Personal Consumption Expenditure Index (PCE) recognizes that as prices change, consumers can adjust their spending to match. For example, if meat prices rise 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 rise in overall price levels. This is the preferred state, as general price increases improve the likelihood that citizens will be able to maintain the desired standard of living. The measurement of core inflation is also important in indicating the direction of real and potentially permanent price changes, which is used in drafting government policy. In essence, key inflation data tells governments which sectors of the economy need attention and need the development of programs to curb further price increases.
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