Core Inflation: Meaning and Impact on Investing

Monetary policy has a significant impact on both wage inflation and headline inflation. Central banks can influence wage inflation by adjusting interest rates, which affect borrowing costs and, therefore, the cost of labor. When interest rates are low, businesses can borrow more cheaply, leading to increased investment and employment. However, if interest rates are too low, inflation can rise, leading to a decrease in the purchasing power of wages. Core inflation is a measure that excludes certain volatile components of the price index, such as food and energy prices, in order to provide a clearer picture of underlying inflation trends.

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In scenarios like this one, a focus on core inflation could forestall a needed policy change until it is too late. As a result, too much monetary policy accommodation may have taken place recently, causing the economy to overheat. Future events will reveal if this is the case, or if the rise in core inflation can be painlessly reversed without a recession. Conceptually, core inflation could be any measure of inflation that attempts to strip out price volatility, but the most common definition of core strips out only two particularly volatile categories of goods, food and energy.

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For example, sectors that are more heavily reliant on low-skilled workers may see higher levels of wage inflation, while sectors that are more capital-intensive may see lower levels of wage inflation but higher levels of price inflation. But core CPI, which factors out more volatile categories, tells a more nuanced story. If headline inflation rises toward core inflation, the Fed will raise rates again. But – and this is the key point – even if headline inflation reaches core inflation, we could still be in an environment where the real Fed Funds is below 2%. Other methods of calculating core inflation include the outliers method, which removes the products that have had the largest price changes.

Headline versus Core Inflation in the Conduct of Monetary Policy

Headline inflation is the broadest measure of inflation, as it includes all goods and services in the consumer price index (CPI) basket. Headline inflation can be influenced by a wide range of factors, such as changes in energy prices or fluctuations in the exchange rate. As a result, it can be a volatile measure of inflation that can fluctuate significantly from month to month. Headline inflation is a raw figure headline inflation vs core inflation that reflects changes in the consumer price index (CPI) throughout the entire economy. It differs from core inflation, which is CPI adjusted to exclude food and energy prices, which are volatile. Headline inflation is a useful measure of how the cost of living might fluctuate on a monthly or yearly basis.

1. However, if productivity growth is stagnant, businesses may need to raise prices to maintain their profit margins, leading to higher inflation.
2. Central banks can influence wage inflation by adjusting interest rates, which affect borrowing costs and, therefore, the cost of labor.
3. Headline inflation, on the other hand, refers to the overall increase in the prices of goods and services in an economy over time.
4. Similarly, investors may adjust their portfolios to include assets that provide a hedge against inflation, such as commodities or real estate.
5. Headline inflation is usually quoted on an annualized basis, meaning that a monthly headline figure of 4% inflation equates to a monthly rate that, if repeated for 12 months, would create 4% inflation for the year.
6. Similarly, if oil prices increase due to geopolitical tensions, it can lead to higher energy prices, which can also increase headline inflation.

Historical analysis has shown that core inflation and inflation expectations are closely related. For example, research has found that changes in core inflation are a good predictor of future changes in inflation expectations. This finding suggests that core inflation can be used as a reliable indicator of future inflation trends.

Moreover, history has shown that inflation expectations can influence core inflation. For instance, if people expect prices to rise, they may demand higher wages, which could lead to an increase in core inflation. Some economists argue that core inflation can be used as a leading indicator of business cycles. According to this view, when core inflation rises, it signals that the economy is entering a period of expansion. The rationale behind this theory is that when demand for goods and services increases, firms are forced to raise their prices, leading to a rise in core inflation. As such, core inflation can provide valuable information about the state of the economy and help policymakers make informed decisions.

Psychological factors also play a crucial role in the link between core inflation and inflation expectations. People’s perceptions and beliefs about inflation can affect their behavior and influence their expectations. For example, if people believe that inflation will increase, they may hoard goods and services, leading to a temporary increase in prices. Moreover, people’s perceptions of inflation may be influenced by various factors, such as media coverage, government policy, and social norms.

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. Also, oil and gas are commodities and are traded on exchanges where traders can buy and sell them. The speculation of energy and food commodities leads to volatility in their prices, causing wild swings in the inflation figures. The effects on inflation can be brief, meaning they ultimately correct themselves and the market returns to a balanced state.

A modified version called the Lowe Index is also used if the data for quantities consumed is not available for the reference period.

1. Understanding this link is crucial for policymakers and investors who seek to predict future economic trends and manage inflation effectively.
2. Understanding the difference between core inflation and headline inflation is important for investors, policymakers, and consumers alike.
3. Hilton’s Tom Maher discusses the market’s challenges and opportunities in SMID stocks after recent turbulence, with insights on what investors can expect ahead.
4. The Federal Reserve has indicated that it plans to keep interest rates low for the foreseeable future, which could help to mitigate some of the inflationary pressures in the economy.
5. Robert Rich and Charles Steindel, “A Review of Core Inflation and an Evaluation of Its Measures,” Federal Reserve Bank of New York, staff report no. 236, December 2005.
6. Core inflation is a measure of the long-term trend in the price level of goods and services that are consumed by households.

Private commercial banks are only permitted to issue demand liabilities, such as checking deposits. Get Vanguard news, insights, and timely analysis on the market, delivered straight to your inbox. The theoretical explanation is higher rates imply a higher discount rate on future earnings, hence a lower valuation. That goes a long way toward explaining the 25% selloff in the SPX in 2022 when the Fed raised its policy rate from 0.00% to 4.33% – but also makes it difficult to accept the rebound 25% rally in 2023 when Fed Funds rose another point.

Why Monetary Policy Should Focus on Core InflationBecause households care about the prices of all the items they buy, it clearly does not make sense to pretend that people do not eat or drive. Thus, I have no qualm in stating that controlling headline inflation, not core inflation, is‑‑along with maintaining maximum sustainable employment‑‑the ultimate aim of monetary policy. Nonetheless, I will argue that it is still useful for monetary policy makers to focus on core inflation when deciding how to respond to incoming economic news.

Additionally, core inflation may not reflect the inflationary pressures faced by certain regions, such as areas with higher housing costs. Examining wage inflation and headline inflation in different industries provides valuable insights into the relationship between the two economic indicators. While the impact of wage inflation and headline inflation varies depending on the industry, case studies can help policymakers and business leaders understand the connection and make informed decisions.

By understanding core inflation and its relationship with interest rates, investors can make informed investment decisions. Inflation and interest rates are two of the most important indicators of an economy’s health, and investors around the globe keep a close eye on them. Understanding these concepts is crucial for anyone who wants to make informed investment decisions. Inflation is the rate at which the general level of prices for goods and services is rising, while interest rates are the cost of borrowing money. Core inflation is a subset of inflation that excludes volatile items such as food and energy prices.