Why would you want to measure inflation without food and energy prices? Those prices fluctuate daily along with the price of oil, which is traded on the commodities market. Oil prices are highly volatile, because commodities traders can bid up oil prices if they suspect actual oil supply or demand will change in the future. They are volatile because they based on quick-changing emotions, not slow-changing supply and demand.
Gas prices are directly tied into oil prices, and change every week or sometimes even every day. That's because people must buy gas every day to get to work, so demand is inelastic. The same is true with food. When you're out of gas or food, you can't delay the purchase until prices fall. Food prices rise along with gas prices because transportation is dependent on trucking, which consumes a lot of gas. When oil prices rise, you'll see the effect about a week later in gas prices. If gas prices stay up, you'll see the effect in food prices a little later.
Since food and gas prices are so volatile, the government needs a measurement that excludes them to get a truer picture of underlying inflation trends. That's because the main tools the Federal Reserve uses to manage inflation is controlling interest rates. You don't want interest rates to bounce up and down each week along with gas prices.
How Does the Fed Use the Core Inflation Rate?The Fedâs tools are slow-acting. It can take 6-18 months before the effect of a change in the Fed funds rate will have an effect on inflation.
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. To stay in business, companies must lower their prices. This reduces inflation.
The Fed also uses inflation rate targeting. It won't take action if the core inflation rate is 2% or lower. If the core inflation rate starts to creep above that inflation target, and stays there, the Fed has got to consider raising interest rates, or other contractionary monetary policy. The Fed has to weigh this with its other mandate, encouraging economic growth and creating jobs. For more, see What Is Being Done to Control Inflation?
For example, inflation increases during the summer, when gas prices increase due to the vacation driving season. However, the Fed would not want to increase interest rates every summer, and lower them every fall. Instead, it must wait to see if those increases drive up the prices of other goods and services. If gas and oil prices stay high for a long period of time, they will eventually drive up the prices of everything else. That's why the Fed looks at both the headline inflation rate, which includes food and energy prices, as well as the core inflation rate, which does not.
How Is the Core Inflation Rate Measured?The core inflation rate is measured by both the core CPI and the core PCE price index. In January 2012, the Federal Reserve reported at its FOMC meeting that it preferred to use the PCE price index because it gave a better indication of underlying inflation trends. That's because the core PCE price index is even less volatile than the core CPI. The Bureau of Economic Administration (BEA) measures prices changes using the Gross Domestic Product data, adds monthly Retail Survey data, and adjusts them to consumer prices using the CPI itself. It uses a different formula than the CPI to compute its estimates, and the formula it uses smooths out any data irregularities.
Bureau of Labor Statistics (BLS) collects the prices of good and services sold by 23,000 businesses based on a survey of 14,500 families. As you can imagine, this is 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 BEA and the BLS simply take out the prices of any food or energy goods sold.
Why Does the Core Inflation Rate Need to Be Monitored So CloselyInflation is when the prices of the goods and services you buy continue to go up over time. If you're 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, or when prices rise in something you already own, like your home or stock portfolio. That's known as asset inflation or an asset bubble.
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 one or two percent increase. It can actually have a bit of a positive effect at that rate, because you will stock up on goods that are on sale because you know the price will rise in the future. This increases demand, which stimulates economic growth.
However, over time, inflation robs the economy of growth potential. That's because people spend more and more on essentials, like food and gas, and less on other consumer products. Those other businesses are less profitable, and some will close down over time. This lowers the country's economic output, or Gross Domestic Product. Article updated April 18, 2012