Inflation Measures

Today’s Consumer Price Index report came in a bit higher than expected:

On a seasonally adjusted basis, the CPI-U rose 0.6 percent in March, following an increase of 0.4 percent in February. Energy costs advanced sharply for the second consecutive month–up 4.0 percent in March… The index for all items less food and energy, which rose 0.3 percent in February, increased 0.4 percent in March.

This counterbalances yesterday’s Producer Price report, which showed a slight fall in inflation (on a 12-month basis) once food and energy are excluded.

But why do economists pay any attention to the “core” inflation rate – i.e. the rate excluding food and energy prices – in the first place? The reason is not because the core rate more important than the overall inflation rate, but rather because it tells us something different from the overall inflation rate. The general inflation rate tells us what is actually happening to consumer’s purchasing power. That is important information, and the most relevant when considering certain types of questions (such as what’s happening to real wages).

But much of the variation in this rate is simply due to wild swings in food and energy prices. So it is often the case the an uptick in inflation one month due to higher oil prices, for example, will simply be reversed the next month by lower oil prices. The core rate therefore gives us a better sense of what the average inflation rate looks like over many months or years. (Note that there are other inflation measures that do much the same thing.) The following chart illustrates.

The core rate is much more stable than the overall rate, simply because food and energy prices are so volatile. Sometimes the overall rate is higher than the core, sometimes lower… so if you read too much into what’s happening to the overall inflation rate you will often be mislead about inflation trends due to temporary blips. For example, if one looked only at the overall rate, one might have concluded in late 2002 and early 2003 that inflation was moving dramatically higher, to around 3%. But the core rate told us that that rise in overall inflation was likely temporary and would be reversed, as indeed it proved to be.

The other reason that the core rate matters is because it gives us much better insight into the underlying condition of the economy. When the core rate is low, that suggests a broad-based lack of pricing power, which generally coincides with weak economic growth. On the other hand, if the overall inflation rate is low, that could simply be due to a temporary fall in oil prices, which may have nothing to do with underlying economic conditions. Similarly, a rise in the core rate, such as we’ve seen over the past year, provides a good indicator that firms are encountering growing demand.

So while the overall inflation rate is useful if you just want to know what’s happening to individuals’ purchasing power, it’s worth keeping your eye on the core rate too.