What does ‘core’ inflation mean anyway?

John W. Schoen Senior producer • Profile • E-mail

Last week's reports on a strong uptick in prices has readers wondering how worried they should be about inflation. And why do policy makers at the Federal Reserve insist on looking at so-called "core" inflation — which eliminates the cost of rapidly rising food and energy prices?

Core inflation is at 2 percent, excluding food and fuel. Nobody can choose to not buy food and fuel. What is the core number based on? And why does it matter if most of my budget is not counted and groceries are way more than 2 percent above last year?
— Elizabeth K., Ellsworth, Maine

These data aren’t designed to reflect the individual experiences of each consumer. They’re designed to track broad changes in prices across all product categories.

So the prices you pay — your own personal inflation rate – will likely have little to do with the monthly national average statistic. Yes, food and gasoline costs are going up. But the cost of a big screen TV is going down. (That makes up for a lot of eggs.)

So why are food and energy prices excluded from the “core” number economists and the Fed watch closely? Yes, the trend in energy prices today is upward — but the price of crude has fallen by more than $10 a barrel in the past month. The same thing happens with food prices: A drought in a farm region can force up short-term prices dramatically. But when the next crop comes, they fall back again.

The idea is to filter out the price of commodities that are subject to big moves over short periods. If you don’t, inflation numbers can bounce around quite a bit from month to month. The Fed can’t have an impact month-to-month; changing interest rates is more like turning a supertanker. A cut in rates today can take months to flow through the system. So the Fed looks at longer trends. Eliminating food and energy "smooths" out the short-term ups and downs of the price of these commodities.

There are other ways economists try to smooth the data. Factory orders, for example, can get thrown off by a single aircraft order moved from one month to the next. So if Boeing lands a big contract, that order skews the overall number way up one month and down the next.

Another widely used “smoothing” method is what’s called a “moving average.” What you do is take the last three months and average those for a monthly number. When the new month comes along, you add the new data point, drop off the one that’s four months old, and average again. So any one-month blip — up or down — gets filtered out.

The Fed also looks at more than the price of goods. Another major component, so-called wage inflation, creeps into the economy when growth is so strong that employers have a hard time finding and keeping qualified workers. When that happens, they have to raise wages to keep their operations staffed and employees have an easier time getting a raise because they can get a better offer elsewhere. So far, both wages and productivity are rising – which means the cost of labor is not adding a lot of pressure to the inflation outlook.

All of which is not to say the Fed isn’t worried about inflation. At the moment, they’re focused on cutting rates to head off a recession and calm the financial markets. But runaway inflation can be worse than recession, which often clears the way for a new period of growth. The only way to stop inflation is to keep raising rates until it stops. And the medicine can be worse than the disease.

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