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What is 'Core Inflation'

Core inflation reflects the long-term trend in a particular price level. It is a measure of inflation that excludes certain items that face volatile price movements because in finding out the legitimate long run inflation, short-term price volatility and transitory changes in price must be removed. Core inflation is most often calculated using the consumer price index (CPI), which eliminates products — usually those in the energy and food sectors — that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation.

BREAKING DOWN 'Core Inflation'

Other methods of calculation include the outliers method, which removes the products that have had the largest price changes. Core inflation is thought to be an indicator of underlying long-term inflation.

Core inflation is calculated by taking the CPI or the core personal consumption expenditures (PCE) index. The calculation for core inflation excludes food and energy prices, most notably oil and gas, because food and energy prices fluctuate based on quick-changing emotions of commodity traders and speculators around the globe rather than the changes in economic supply and demand.

In January 2012, the Federal Reserve declared that it would rather use the PCE index than CPI since PCE provided inflation trends that are less affected by short-term price changes. To get underlying trends that are not affected by short-term price movements caused by traders and speculators, the Bureau of Economic Administration (BEA) calculates the change of prices by using existing gross domestic product data. It also adds in the monthly Retail Survey data and compares them with the consumer prices with the data provided by the CPI. These additions remove data irregularities, providing detailed long-term trends.

The Importance of Core Inflation

It is important to measure core inflation because it reflects the relationship between the price of goods and services and the price of consumers' general income. If goods and services increase over time but the income of consumers do not, consumers will have weaker buying power since the value of their money decreases in comparison to the value of basic goods and services. However, if inflation happens to consumers' income and nothing changes with the prices of goods and services, consumers will have better buying power and can afford more of the same goods and services. When consumers' stock portfolio or home price increase, asset inflation happens, which provides more money for the consumer as well.

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