The core rate is not an evil conspiracy

by Philip Brewer on 17 October 2007 21 comments
Photo: earth_photos

The Consumer Price Index was released today, showing prices were up 0.3% last month and up 2.8% from a year ago. The same report also includes the so-called core rate, which excludes food and energy. Since food (up 4.5% from a year ago) and energy (up 5.3% from a year ago) are the principle contributors to increases in the cost of living, the core rate was naturally lower--up 0.2% (2.1% from a year ago). Except for making things sound better than they are, what's the benefit in talking about the core rate?

There are plenty of people out there who think the core rate is, if not an evil conspiracy, nevertheless a deliberate effort to disguise inflation, intended to fool the public. (Another name for the core rate is "inflation ex food and energy" and more than one wag has referred to it as "inflation ex inflation," in reference to the fact that they're subtracting out exactly the things showing the highest price rices.) The fact is, though, there's a use for the core rate.

Inflation versus falling living standards

When the Federal Reserve makes decisions about monetary policy, the most important factor is inflation. The thing is, though, inflation is difficult to get a handle on. Inflation isn't just rising prices. Inflation is money becoming less valuable.

Graph of CPI versus core CPIThere are other things that look a lot like inflation, but that aren't "money becoming less valuable." If a drought results in food becoming more expensive, that's not inflation, even though food prices are going up. (Contrariwise, if technological improvements make electronic equipment cheaper, falling prices of computers and cell phones are not deflation.) It's not that the money got less valuable, it's that people's standards of living have fallen.

Now, having prices go up and standards of living fall is going to feel a lot like inflation to everyone. But the Fed has to be very careful not to treat it like inflation. If it did that, it'd be liable to produce a recession, which would just make standards of living fall even further.

The core rate can sometimes provide an important clue.

Take a look at this graph, showing CPI and Core CPI for a few years in the 1980s. When oil prices dropped sharply, the CPI dropped sharply as well. The core rate, though, barely budged. That was an important clue to the Fed that there was no danger of deflation, and they were able to hold monetary policy steady. Sure enough, when oil prices went back up, the core rate returned to a level very close to the CPI.

Currently, food and energy prices are rising sharply. That's going to cut everyone's standard of living. (Especially that of the poor and middle class, but even the rich buy food and fuel, and every dollar that they have to spend on basics is a dollar they can't spend on fine art or a fourth summer home.) Is it inflation? Or is it just the price effects of flat oil supplies?

Spotting inflation

You can only really know whether it was inflation after the fact. First, there are the changes in relative prices (oil goes up, due to high demand, but other prices stay the same--or even drop, because people are spending so much buying fuel, they can't afford to spend as much on shoes and toys). Second, there are the knock-on effects as all the other prices adjust to changes in the prices of inputs (more expensive oil makes producing everything else more expensive, because everything uses oil). But, if there's no inflation, it's pretty much a one-shot deal: Changes in relative prices ripple through the economy, everything adjusts to the new reality, and then things are stable again. Inflation, though, doesn't stop--prices just keep rising.

Graph of CPI versus Core CPIWaiting to see that prices just keep rising is not a good way for the Fed to stay on top of things, though. So, they're always looking for early clues as to whether we're facing inflation.

There are a lot of such clues. One is a falling dollar (which we've been seeing lately). Another is rising gold prices (we've been seeing that too).

Here's another graph of CPI versus core CPI, this one showing recent data. Here we see CPI is all over the place, but again the core rate is generally holding to the middle--and just recently has turned down. In fact, the core rate peaked a year ago and has been trending down ever since. The most recent CPI is above the core rate, but it was below the core rate just a month ago--and was way below the core rate a year ago, and way above it just a month before that.

To my eye, this does not look like inflation about to take off. That's not to say that inflation won't take off--the most recent Fed rate cut could certainly lead to higher inflation, especially if it's followed up by further rate cuts. So far, though, the value of the money looks to be under control.

That's not to say that prices are under control. Energy prices and food prices are spiking up big time. That's a big deal for households. But the big deal is that standards of living are falling. There are ways to address that, but raising rates to fight off inflation is not one of them.

There's an obvious absurdity in reporting a measure of inflation where you've you subtracted out the two things everyone buys that have prices rising the fastest. Despite that, the core rate is a useful tool for getting an early clue about whether what you're seeing is inflation (declining value of money) or a drop in the standard of living (everybody getting poorer). That's why the government calculates it, why it gets reported on the news, and why the Fed pays attention to it.

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Guest's picture
Jason

Thank you! I have always scorned that statistic, because I thought WHAT'S
The POINT! If I didn't have to eat it might help me out. But it makes sense now. Thanks for the effort.

Guest's picture
Marisa

Thanks for this useful & informative article!

Andrea Karim's picture

That was a really cool article, Philip. I'm still struggling to get my mind wrapped around these concepts, but I'm glad you illustrated why things are calculated the way they are.

Damn, though. There goes one more favorite conspiracy theory.

MikeCinFLA's picture

Understanding that nobody can predict the future, is there a index I can feel confident using in my financial planning to figure out what my lifestyle will cost me in 5, 10, 15 years?

Philip Brewer's picture

There are three things you need to pull apart to look at future expenses.

Inflation is actually the easiest, because it doesn't change the relative prices of things, it just changes what we call those prices. (That is, we used to call it $100 and now we call it $200, but it's really the same value in terms of the number of hours we have to work to pay for it or in terms of what other goods or services we could swap for it.)

The killers for predicting future costs are:

1) Changes in relative costs. Who would have figured that advances in technology, combined with manufacturing overseas would give us $49 DVD players? It was only 15 years ago that I spent over $100 on the absolute cheapest CD player available and figured I'd gotten the deal of a lifetime. Medical care has gotten vastly more expensive, but has also gotten a lot better. Housing has gotten more expensive without getting significantly better (except for getting bigger).

2) Changes in standard of living. Critical resources like oil are going to get more expensive, making us all poorer.

I think the best way to control your expenses going forward will be to own stuff (where you can) and to stay flexible (everyplace else). Stuff that you own is stuff that you don't have to worry about the future price of. Stuff that you can't own... you simply have to accept that you'll need to adjust to the future realities as far as buying it in the future--accept that you may have to make do with substitutes.

I wrote a bit a while back specifically about buying things now to take advantage of the cheap energy that's available now in a piece called Fix energy in tangible form.

Sorry I don't have a number for you.

Guest's picture
Rebecca

Sometimes Wise Bread is more informative than school! Thank you, Philip. As always, a useful, informative article which emphasizes areas people don't always know, but should!

Guest's picture
Kelja

The CPI is useless. It has been massaged and manipulated by ever administration since LBJ, and for good reason. Payments to entitlement programs, like SS, are tabbed to the CPI. CPI is up, gov has to pay more out.

When the CPI is showing higher inflation figures than is comfortable, they simply change the way it's calculated. For example, housing prices have been left out for the past few years. If it wasn't inflation would be shown to be rampant. Instead they subsituted the price your house could rent for - a figure that hasn't kept up with home prices.

They make use of subsitution in many other areas. If the price of beef steak rises too much, they replace it with hamberger meat. The rational is that people would switch.

They use hedonics. They measure some things by their supposed productivity. For example, with a computer. A computer you can purchase for $2000 today is much more powerful than a computer purchased 5 years ago, therefore this is given much more weight in calculating the CPI. Even though the new computer is accomplishing much the same thing the old one did.

The CPI is pure scam, a scam most fall for. Inflation is nothing more than the amount of dollars in the system. More dollars in the system ultimately results in higher prices. More dollars chasing the same amount, or fewer, assets. The gov used to publish M3 figures which show the amount of dollars in the economy. They stopped doing that last march because it became an embarrassment. It showed how the gov is pumping the system full of trillons of dollars essentially created out of air.

If you want a real gauge of inflation, simply look at the cost of a postage stamp, hamberger or loaf of bread, or gold. Gold is an excellent barometer, it was selling at $260 in 1999 and now is $760, an increase of 200% in that time.

What's next, possibly hyperinflation.

Guest's picture
Kelja

The CPI is useless. It has been massaged and manipulated by ever administration since LBJ, and for good reason. Payments to entitlement programs, like SS, are tabbed to the CPI. CPI is up, gov has to pay more out.

When the CPI is showing higher inflation figures than is comfortable, they simply change the way it's calculated. For example, housing prices have been left out for the past few years. If it wasn't inflation would be shown to be rampant. Instead they subsituted the price your house could rent for - a figure that hasn't kept up with home prices.

They make use of subsitution in many other areas. If the price of beef steak rises too much, they replace it with hamberger meat. The rational is that people would switch.

They use hedonics. They measure some things by their supposed productivity. For example, with a computer. A computer you can purchase for $2000 today is much more powerful than a computer purchased 5 years ago, therefore this is given much more weight in calculating the CPI. Even though the new computer is accomplishing much the same thing the old one did.

The CPI is pure scam, a scam most fall for. Inflation is nothing more than the amount of dollars in the system. More dollars in the system ultimately results in higher prices. More dollars chasing the same amount, or fewer, assets. The gov used to publish M3 figures which show the amount of dollars in the economy. They stopped doing that last march because it became an embarrassment. It showed how the gov is pumping the system full of trillons of dollars essentially created out of air.

If you want a real gauge of inflation, simply look at the cost of a postage stamp, hamberger or loaf of bread, or gold. Gold is an excellent barometer, it was selling at $260 in 1999 and now is $760, an increase of 200% in that time.

What's next, possibly hyperinflation.

Guest's picture
Scott

if the government provided a tool so that one could personalize their inflation rate.

For example, I live in NYC and I am single, so my inflation rate is obviously different than a family of 5 in surburban Indianapolis, or even a single person with a child and car who lives in NYC.

So, you could check off what your expenses were based on lifestyle...in my case there would be no check for gasoline, but there would be for rent. Then, adjust for location and voila!

Keep the asskicking posts coming, Philip!

Guest's picture
itstarted

Kelja on Thu has it right.
"Core Inflation" a gambit.

As a retired citizen, who stands to gain or lose in Social Security Payments based on the CPI, I'd like to quote just a few increases in my own budget, that are excluded from the current 2.3% core increase that will represent inflation adjustment..

healthcare - 8.4%
healthcare supplement 9.6%
medicare part D - 12.5%
electric bill 16.7 increase
gas bill 9.4% increase
nursing home insurance 12.7%
water/sewer 40% increase
food (from budget actuals) 19%
Gas... same- but from 10,000 mi. to 7,500
house insurance (inland Florida no Hurricanes) 137.5%
fire insurance 13.9% increase
house taxes 7.1% increase

now... as to the "core". That $700 laptop from last year is now only $549, but I can't afford it anyway... and the intrinsic increased value of my new shoes that should last longer, won't do me that much good, because I won't live that long.

Philip Brewer's picture

The annual cost-of-living adjustment in Social Security payments are not based on the core rate, but rather on CPI-W (one of the sub-indexes of the CPI). Details are here (on the Social Security Administration's web site):

http://www.ssa.gov/OACT/COLA/colasummary.html

I'm totally with you on the CPI understating actual inflation (as anyone who keeps track of their household expenses from year to year can verify). The details vary enormously from household to household, of course. (My renters insurance didn't go up nearly as much as your homeowner's insurance, for example, plus it's a much smaller portion of my annual budget.)

I'm actually planning another article on the CPI, that will talk about "hedonic adjustments"--how the CPI is adjusted to try to account for the fact that some goods (such as computers) have about the same price from one year to the next, but are actually better. It's not a crazy idea, but I think it's done in a way that cause the CPI to understate inflation.

This post, though, was just about the core rate. That's a useful value for making policy decisions. I don't think anyone uses it to adjust cost of living for anything.

Guest's picture
fallout11

When one compares the present cost of goods and services that have remained essentially unchanged in form or functionality since the 1950's (example: postage stamp, ice cream cone, haircut, gallon of gas, gallon of milk), one can easily see that the government is massaging the numbers. From BLS unemployment statistics to hedonic adjustments to monetary and credit expansion, the US has an entire Ministry of Propaganda hard at work on misleading and misdirecting anyone interested in the economics of the matter.
Welcome to the Ministry of Propaganda. Of course you won't find any sign proclaiming a building in Washington D.C. the Ministry of Propaganda, but the ministry exists in a decentralized fashion, reaching into every fiber of the government and the private sector.
Like the Devil, the MOP's most successful propaganda campaign is the one denying its own existence.
The US has become a giant Enron, nothing but lies, lies, and lies.
1) Bogus inflation numbers.
2) The unemployment rate is also manipulated down.
3) GDP is back-adjusted lower every quarter.
4) Balance sheets of corporations, pension funds and government agencies massively understate liabilities and overstate assets/future earnings.
5) Visibly laughable lies are mouthed by top officials with a straight face.

The Propaganda Ministry has waged a successful campaign. It has convinced people that apathy is concern, liabilities are assets, inflation doesn’t exist, debt is money and growth, peace is war, terror will be ended by war, and any news is good for stocks. The Prop Min has gotten people to accept that the only way to support soldiers is to keep them in harms way and to suggest otherwise is unpatriotic.

Apparently people also believe that recessions are evil, destruction of purchasing power creates a strong currency, discouraged workers are not unemployed, and that people in this country illegally are entitled to the rights and privileges of legal citizens. All but a few believe the Fed is both omnipotent and omniscient, and craven morons have Ph.D’s or Nobel Prizes so they must be smart and capable of governing effectively.

Now the Prop Min is working on getting us to accept that worthless assets are worth what ever mythical value assumed so long as the assets are never subjected to price discovery in an open market.
How do fundamentals have meaning in an environment where reality and truth have little or no value? How does one prosper and protect that prosperity?
Welcome to the world of the market technician.

The best single source for information on the "real" rate of inflation (roughly 6-7%, not the phony 2% cited by our government agencies and the Fed) is John Williams' Shadow Government Statistics Analysis Behind and Beyond Government Economic Reporting.
http://www.shadowstats.com/cgi-bin/sgs?

Guest's picture
fallout11

Well, since that attempt to link didn't work, here it is in simple format.
http://www.shadowstats.com/cgi-bin/sgs?

Philip Brewer's picture

I want to write a post on hedonic adjustment. I don't doubt that it is producing a bogus CPI, but it's really hard to know by how much. I mean, hedonic adjustment is a legitimate concept--a car that lasts for 20 years really is worth more than a car that last for 4 years, and a $3000 computer bought this year is almost immeasurably more valuable than a $3000 computer bought in 1984.

Guest's picture
fallout11

Followup: Even Moneyweek Magazine is no longer buying the 'official' (fake) statistics.
"The US economy is in terrible shape! Our government has been psychologically manipulating the American people every time they publish blatantly false data on employment and income that makes our economy look stronger than it really is. If the average American realized how bad things were, they might try to save more. But spending would collapse if they did, so the goal of the Bush Administration seems to be to hide any signs of a recession as long as possible.

If you don’t see it, it must not be there For those familiar with the government releases, the Bureau of Labor Statistics ("BLS") just posted a benchmark data revision that showed the total number of workers employed on the payroll survey was 300,000 less than originally estimated for March 2007 (900,000 versus the 1,200,000 that was reported).

By the time the dust settles, and later benchmark revisions come in for the whole year, it is likely that all of the jobs added by the BLS Birth/Death Model in 2007 will be fictitious. This could mean there hasn’t been any job growth at all! Without the fiction of job growth, you can imagine how much worse it will be for consumer income, spending, and sentiment not to mention business investment plans."

http://www.moneyweek.com/file/39162/why-this-christmas-will-be-the-us-ec...

Guest's picture
k8e

Thanks for the article and the excellent explanation. So core inflation may not be as high as we feel from our day to day experience with prices. But even so, how can the value of money not be dropping like a stone the way the government is printing it like mad? Also isn't the declining value of US money against foreign currency a sign that our money is losing value?

Philip Brewer's picture

The explanation of the core rate is still valid, but the current situation has changed a bit since this article was written back in October.

At that time, inflation was a concern--prices were rising and the dollar was dropping--but it looked like there was a good chance we could all just muddle through, as long as the Fed didn't start aggressively cutting interet rates. Then the Fed started aggressively cutting interest rates, because of the credit squeeze related to the subprime debt crisis.

Since then the CPI has jumped sharply higher, and the core rate has turned back up as well. The dollar has continued to drop and the price of gold has soared, along with the price of oil. All in all, it looks like a round of serious inflation is in the cards. (The Fed could prevent it, but doing so would probably bring down the whole banking system, which the Fed would never do.)

Guest's picture
Inflationhawk

You can check your own personal inflation rate at http://myinflationrate.com

Guest's picture
Guest

I have to disagree with the premises of your argument. You make a lot of really good points but i think you are confused about what inflation is. As I understand, inflation is an increase in the quantity of money absent an equal increase in economic activity. The CPI in my opinion reflects the effects of inflation and not inflation itself. Yes, higher demand for food and energey reduce the standard of lliving. But, if the demand is artificially created through monetary and fiscal policy is this not the result of inflation.

Philip Brewer's picture

There's persistent debate about what inflation is. Is it rising prices? Increasing money supply? I choose to take a middle course: Inflation is the money becoming less valuable. The cause is usually growth in the money supply faster than growth in the economy, and the result is usually higher prices, but inflation is the money becoming less valuable.

I find it most useful to look at the issue that way because excess growth in the money supply can have very complex results. (For example, in the 1990s and 2000s the result was first a stock market bubble and then a housing bubble, rather than higher consumer prices.) Similarly, rising prices can have causes other than inflation.

Guest's picture
Guest

I also wanted to point out that the value of money seems to be holding. Have you heard of the flight to safety. Could the fact that the dollar is holding value during a massive devaluation be that it is being artificially propped up by its perceived safety during times of turbulence. What if that goes away. I am no economist by any stretch of the imagination but I see danger around every corner.