Core Inflation Is Probably A Better Measure Of The Trend

Inflation is topical again. The crowd is becoming increasingly concerned that a combination of factors, including ramped-up fiscal spending and ongoing monetary stimulus, will conspire to unleash firmer pricing pressure. By some accounts, inflation is set to spiral higher and threaten the price stability that’s prevailed for several decades.

But the future’s still uncertain and so there’s a lively debate about how much a threat inflation actually poses. That’s in part because the economic and demographic forces that created disinflationary trends aren’t going away — aging workforce, global savings glut, expanding array of technologies that enhance efficiency, etc.

Regardless of how you’re thinking about inflation, monitoring the trend is a top priority these days and on that front core measures are usually the better choice over the more widely reported headline counterparts.

Core inflation strips out energy and food prices from mix, an adjustment that often elicits howls of criticism from some corners. Consumers, after all, don’t have the luxury of living in a core-inflation world. True, but the goal of core inflation is not to estimate how current inflation is affecting the overall population. Rather, the aim is two-fold: estimate a robust measure of the inflationary trend with an eye on making a reasonable forecast of where it’s headed. By those standards, core measures of inflation are usually the better choice.

Let’s dig into the numbers to illustrate why that’s so. Before we begin, we’ll cut to the chase and note that core inflation continues to reflect low and, in recent history, a declining inflationary trend. The core Consumer Price Index (CPI), for example, slipped to a 1.3% annual pace in February (red line in chart below) – close to the lowest rate in over a decade and well below the Federal Reserve’s 2% inflation target.

Why should we put more stock in core inflation vs. headline? Let’s start with an empirical fact that’s clearly illustrated in the chart above: headline CPI fluctuates relatively widely around core. Sometimes headline inflation is substantially higher, sometimes lower. But headline inflation never permanently diverges from core and so history suggests that headline volatility is closer to noise relative to core’s signal.

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Disclosures: None.

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