Two Measures of Core Inflation: A Comparison St Louis Fed

Both the government and central bank (Reserve Bank) try to tackle inflation with their policies which are known as Fiscal and Monetary Policies respectively. This example clearly explains the fall in the purchasing power of money. The calculations for a trimmed mean and median CPI are fairly straightforward, but the difficulty with them is that they are based on weighted averages. (All of the groupings in the CPI basket have different weights, based on consumption patterns.) Dealing with the weightings makes the calculations look more complicated than they really are. Inflation rates can increase due to several factors, including higher production costs and a surge in demand for products and services.

As a result, too much monetary policy accommodation may have taken place recently, causing the economy to overheat. Future events will reveal if this is the case, or if the rise in core inflation can be painlessly reversed without a recession. Relying on core inflation for policymaking has its drawbacks, however. There is no inherent reason that changes in food and energy prices cannot be caused by changes in aggregate demand. For example, rapid spending growth could push up energy prices if supply does not rise in response.

1. Administrative measures taken by the government like the strengthening of the Public Distribution System also play a crucial role in curbing inflation.
2. Inflation rates can increase due to several factors, including higher production costs and a surge in demand for products and services.
3. The products vastly improve in quality, while the prices remain flat.

The Bank of Canada states its target in terms of the headline consumer price index, and although this choice of inflation measure contrasts with the Federal Reserve’s preferred index, the difference is not nearly as great as it appears on the surface. In fact, the Bank of Canada monitors core and headline inflation difference a number of inflation measures and uses core inflation as an „operational guide“ in coming to its monetary policy decisions and discussing these decisions with the public. Most central banks describe their price stability goals in terms of the behavior of an all-items price index.

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Robert Rich and Charles Steindel, „A Review of Core Inflation and an Evaluation of Its Measures,“ Federal Reserve Bank of New York, staff report no. 236, December 2005. The study examines the forecasting power of inflation less food and energy, as well as alternative definitions of core inflation that have been proposed by others. Though high rates are not good for the economy, mild inflation, say under 3%, may turn, at times, useful for the economy. As we hinted in the beginning, inflation can occur because of high demand too.

Board of Governors of the Federal Reserve System

In recent years, headline inflation has typically outpaced core inflation, as seen in Figure 1, because of the rapid rise in energy prices. In 2007, headline inflation was also driven up by a 3.9% increase in food prices. The difference between core and headline has not always been trivial—from 2003 to 2006, core inflation was 0.9 percentage points lower than headline.

The most commonly cited measure of inflation is the percent change in the consumer price index (CPI).4 This index measures the price of a basket of consumer goods and services that is representative of overall consumer purchases in urban areas. When food and energy prices are omitted from the CPI, the remaining basket is commonly referred to as the core CPI. The overall measure of CPI, which includes food and energy, is often referred to as the headline CPI. Another common measure of inflation is the percent change in the GDP (gross domestic product) price deflator, which is used to transform nominal GDP into real GDP. Since the GDP deflator is based on the prices of all goods and services in the economy, it is a broader measure of inflation than the CPI.

Inflation causes the value of money or income to decrease in comparison to the prices of basic goods and services. The chart above indicates that the two measures have not greatly diverged in the long run. I chopped down the period shown to be the low inflation period of 1994 to present.

Inflation Rates in India

In this case headline inflation will rise well above its underlying trend as the price of energy rises but will soon fall well below its underlying trend as the price of energy falls back to its initial level. On average, inflation will remain unchanged without any monetary policy action. The outcome of such a policy would be a more pronounced fall in inflation with a decline in employment.

Of course, to the extent that such a bias in a core inflation measure is stable or predictable, the central bank could easily take this into account in setting monetary policy. But even in that case, differences in average rates of inflation between the core measure and overall inflation could complicate communication with the public. Here in Canada, unlike in the United States, the central bank maintains an explicit inflation target.

Two Measures of Core Inflation: A Comparison

Since 2008, however, the difference has been smaller, 1.7 percent and 1.4 percent. While excluding food from core inflation has become conventional, it may no longer be warranted. The volatility of food has decreased significantly since the 1970s.7 Until 2007, the recent divergence between headline and core inflation was driven by energy prices. In 2007, food prices rose rapidly—it is too soon to tell whether this development marks a renewed period of persistent volatility.

Most central banks use headline inflation or a similar measure as their target variable. The reason being headline inflation is a broad measure that closely represents the basket of goods and services consumed by most households. Some major central banks that use headline inflation are the Bank of England, the European Central Bank (ECB), and the Reserve Bank of India. Many central banks around the world are mandated to maintain the price level in the economy. The mandate explicitly states the measure of the price level to be used while designing monetary policy. Core inflation is measured by both the CPI and the core personal consumption expenditures (PCE) index.

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For example, TIPS are an inflation-protected bond issued in the United States. The fixed income instruments yield headline inflation plus a small spread. The first step in calculating the lower level index is creating a basket of goods and services consumed by the average consumer.

There are different indices in India like Wholesale Price Index(WPI), Consumer Price Index(CPI), etc. which measure inflation rates in India. But what we generally https://1investing.in/ find in headlines is the rate in India is a rate based on WPI. In the last 50 years, the WPI-based rate shows an average inflation rate of around 7-8%.