What is Core Inflation
Core inflation is the change in costs of goods and services, but does not include those from the food and energy sectors. This measure of inflation excludes these items because their prices are much more volatile. It is most often calculated using the consumer price index (CPI).
BREAKING DOWN Core Inflation
Core inflation is measured by both the CPI and the core personal consumption expenditures index (PCE). Other methods of calculating core inflation 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.
Why Food and Energy Aren't Included in Core Inflation
Food and energy prices are exempt from this calculation because their prices are too volatile. Because food and energy are necessary staples, demand doesn't change much even though prices may rise. Even though gas prices may rise with the price of oil, you will still need to fill up the tank in order to drive your car. Similarly, you won't be pushing off buying your groceries just because prices are rising at the store. It's for this reason that the prices for these goods are not included in the calculation of core inflation.
A New Measure for Core Inflation
In January 2012, the Federal Reserve declared 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 Analysis (BEA) calculates the change of prices by using existing gross domestic product (GDP) data. It also adds in the monthly Retail Survey data and compares them with the consumer prices 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 does 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 prices increase, asset inflation occurs, which provides more money for the consumer as well.