What Exactly is Core Inflation?

Core inflation is an inflationary measure which leaves out specific items which face unpredictable changes in price. Introduced by Robert J. Gordon in a paper written in 1975, core inflation was conceptualized as aggregate price growth excluding food and energy. Used predominantly for political purposes, core inflation was further developed by Otto Eckstein in 1981.

The Federal Reserve prefers the measure of core inflation as the Personal consumption expenditures price index (PCE). The PCE is an indicator of the average increase in prices for all domestic personal consumption, a figure tied to chained dollars.

Chained dollars is a way of adjusting real dollar values for inflation over time. This allows a more accurate comparison between prices from different years. The concept was introduced in 1996; however, current chained dollars reflect figures calculated in 2005 as the base year. You have probably heard people say that something costs X, the equivalent of so many dollars in the year Y – this is a reflection of chained dollars thinking.

The rationale behind eliminating certain products from the core inflationary numbers is that certain items are affected by temporary, and sometimes dramatic, price fluctuations which would give a false result. Especially in a weak economy, fears of inflationary increases can lead to financial mayhem.

In the past few months you may have noticed that the Fed has not responded to the rise in food and fuel prices. That is precisely because the Fed only focuses upon the core inflationary rate, which it views as a better predictor of long term price increases.

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