Core Inflation: What It Is and Why It's Important (2024)

What Is Core Inflation?

Core inflation is the change in the costsof goods and services, but it 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), which is a measure of prices for goods and services.

Key Takeaways

Core inflation is the change in the costsof goods and services but does not include those from the food and energy sectors.
Food and energy prices are exempt from this calculation because their prices can be too volatile or fluctuate wildly.
Core inflation is important because it's used to determine the impact of rising prices on consumer income.

Core Inflation: What It Is and Why It's Important (1)

Understanding Core Inflation

Core inflation is measured by both the CPI and the core personal consumption expenditures (PCE) index. The PCE represents the prices of goods and services purchased by consumers in the U.S. Since inflation is a measure of the trend in rising prices, PCE is an important metric in determining inflation. However, core PCE and CPI are similar, and both help to determine how much inflation is in the economy.

Why Food and Energy Prices Are Excluded

Food and energy prices are exempt from this calculation because their prices can be too volatile or fluctuate wildly. Food and energy are staples, meaning demand for them doesn't change much even as prices rise. For example, gas prices may rise with the price of oil, but you will still need to fill up the tank to drive your car. Similarly, you won't be putting off buying your groceries just because prices are rising at the store.

Also, oil and gas are commodities and are traded on exchanges where traders can buy and sell them. Food, too, is traded including wheat, corn, and pork. The speculation of energy and food commodities leads to volatility in their prices, causing wild swings in the inflation figures. For example, a drought can cause dramatic effects on the prices of crops. The effects on inflation can be brief, meaning they ultimately correct themselves and the market returns to a balanced state.As a result, food and energy prices for these goods areexcluded from the calculation of core inflation.

3.6%

The urban core inflation rate as of May 30, 2024, based on the consumer price index excluding food and energy for U.S. cities.

The Preferred Measure of Core Inflation

The Federal Reserve prefers to use the PCE index rather than CPI since PCE tends to provide inflation trends that are less affected by short-term price changes. Also, the Bureau of Economic Analysis (BEA), a division of the Department of Commerce, calculates the change in prices by using existing gross domestic product (GDP) data, which helps to determine an overall trend in prices. The GDP figure is a measure of the production of all goods and services in the U.S. The BEA also adds in the monthly retail survey data and compares them with the consumer prices provided by the CPI. These additions remove data irregularities and provide detailed long-term trends.

The Importance of Core Inflation

It is crucial to measure core inflation because it reflects the relationship between the price of goods and services and the level of consumer income. If prices for goods and services increase over time but consumer income doesn't change, consumers will have less purchasing power. Inflation causes the value of money or income to decrease in comparison to the prices of basic goods and services.

However, if consumer income rises, called wage growth, while the prices of goods and services remain unchanged, consumers will have more purchasing power. Also, as investment portfolios and home prices rise, asset inflation occurs,which can provide additional money for consumers to spend.

What Is Purchasing Power?

Purchasing power is the value of a currency expressed in terms of the number of goods or services that one unit of money can buy. Purchasing power is important because, all else being equal,inflationdecreases the number of goods or services you would be able to purchase. There can be a significant impact when valuing one currency against that of another nation.

In investment terms,purchasing poweris the dollar amount of credit available to a customer to buy additional securities against the existingmarginable securitiesin the brokerage account. Purchasing power may also be known as a currency'sbuying power.

What Is Volatility?

Volatility is a statistical measure of thedispersionof returns for a given security or market index. In most cases, the higher the volatility, the riskier the security. Volatility is often measured as either thestandard deviationorvariancebetween returns from that same security or market index.

What Is Gross Domestic Product (GDP)?

Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country’s economic health.

Though GDP is typically calculated on an annual basis, it is sometimes calculated on aquarterlybasis as well. In the U.S., for example, the government releases anannualizedGDP estimate for each fiscal quarter and also for the calendar year. The individual data sets included in this report are given in real terms, so the data is adjusted for price changes and is, therefore, net ofinflation.

The Bottom Line

Inflation is one of the key measures of economic health, indicating how quickly prices are rising and how quickly money is losing its value. However, the prices of food and fuel tend to fluctuate more than other commodities, making it difficult to show price trends. By omitting these volatile categories, core inflation is considered a more reliable measure of price growth over the long term.