What Is the Core Inflation Rate?
How It's Calculated and Its Critical Role
The core inflation rate for January 2021 was 1.4% year over year. That means the prices of everything except food and energy rose by 1.4% since January 2020. The core rate excludes food and energy prices because they vary too much from month to month.
This exclusion makes the core rate more accurate than the headline inflation rate in measuring underlying inflation trends. This accuracy is why central banks prefer using the core inflation rate when setting monetary policy.
The core inflation rate was unchanged from December 2020. While some categories, like apparel, saw increases, they were offset by decreases in other categories, like used cars and trucks.
What Is Core Inflation?
The core inflation rate is the price change of goods and services minus food and energy. Food and energy products are too volatile to be included. They change so quickly that they can throw off an accurate reading of underlying inflation trends.
- Alternate Names: Consumer Price Index for All Urban Consumers Less Food and Energy, and Core Personal Consumption Expenditures Index Excluding Food and Energy
- Acronyms: CPI Less Food and Energy, PCE Excluding Food and Energy
Why Food and Energy Prices Are Volatile
Food and energy prices are volatile because they are traded on the commodities market. Most food (like wheat, pork, and beef) and energy (oil, gas, and natural gas) are traded all day long.
For example, commodities traders bid up oil prices if they suspect its supply will fall or demand will rise. They might think a war will dry up the supply of oil. They'll buy oil at today's price to sell at tomorrow's higher anticipated price. That is enough to drive up oil prices. If the war doesn't materialize, oil prices fall when they sell.
Food and energy prices are dependent on rapidly-changing human emotions, not slow-moving supply and demand.
Food prices rise along with gas prices because food is transported by interstate trucking. It consumes a lot of gas. When gas prices rise and stay high, you'll eventually see its effect on food prices in a few weeks.
How the Fed Uses the Core Inflation Rate
The Fed's mandate is to control inflation. It uses interest rates to do this. You don't want interest rates to bounce up and down each week along with gas prices.
The Fed's tools are slow-acting. It can take months before a change in the fed funds rate will filter down to prices.
How does the fed funds rate affect inflation? If the fed funds rate increases, so will the rate for bank loans and adjustable-rate mortgages. As credit tightens, economic growth slows. Companies must lower their prices to stay in business and that reduces inflation.
The Fed uses inflation-rate targeting. It would rather not take action if the core inflation rate is 2% lower compared to last year.
On Aug. 27, 2020, the FOMC announced it will allow a target inflation rate of more than 2% if that will help ensure maximum employment. It still seeks a 2% inflation over time but is willing to allow higher rates if inflation has been low for a while.
What happens if the core inflation rate starts to creep above that inflation target and stays there? The Fed considers raising interest rates and other contractionary monetary policy. The Fed has to weigh this with its other mandate, encouraging economic growth and creating jobs.
The chart below illustrates the U.S. core inflation rate from 1958-2019. Specifically, it's the year-over-year rate as of December for each year. It measures how much prices, excluding food and energy, have increased in the past 12 months.
How It's Calculated
The core inflation rate is measured by both the core Consumer Price Index (CPI) and the core Personal Consumption Expenditures (PCE) price index. In January 2012, the Federal Reserve reported at its FOMC meeting that it preferred to use the PCE price index.
The Bureau of Labor Statistics (BLS) reports the CPI. It surveys the prices of 80,000 consumer items to create the index. It collects this price information from thousands of retail and service companies. It chooses the types of businesses frequented by a sample of 14,500 families.
As you can imagine, this takes some serious number-crunching, and it gives a pretty good indication of price changes. However, it is not as inclusive as the PCE price index.
To get the core inflation rate, both the Bureau of Economic Analysis (BEA) and the BLS take out the prices of any food and energy goods sold.
The PCE price index gives a better indication of underlying inflation trends than the core CPI. It's less volatile thanks to the way it's measured.
The BEA reports the PCE price index. It measures price changes using gross domestic product (GDP) data. It then adds the monthly Retail Survey data. It adjusts them to consumer prices using the CPI itself. It uses a different formula than the CPI to compute its estimates. That formula smooths out any data irregularities.
Why the Core Rate Is Critical
Inflation is when the prices of the goods and services you buy continue to go up over time. If your income doesn't go up at the same rate, then you are losing buying power as prices rise. The only time inflation doesn't weaken your standard of living is when it happens to your income.
Inflation benefits you when prices rise in something you own, like your home or stock portfolio. That's known as asset inflation.
Inflation has a subtle yet destructive effect on economic growth. It's subtle because you may only notice it over time if it's only a 1% or 2% increase. It can have a bit of a positive effect at that rate. That's because you will stock up on goods now because you know the price will rise in the future. That increases demand, which stimulates economic growth.
Over time, high inflation robs the economy of growth potential. If wages don't keep up, then people are forced to spend more of their income on essentials, like food and gas, and less on other consumer products. Those other businesses become less profitable, and some will close down over time. That can lower the country's economic output.