The core rate is not an evil conspiracy
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.
There 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?
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.
Waiting 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.
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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