Core inflation aims to capture the long-term direction of price changes by excluding temporary fluctuations. This allows policymakers and analysts to focus on the underlying trends in inflation, which are more relevant for economic decisions.
The Traditional Approach: Excluding Food and Energy
The most common method for calculating core inflation excludes frequently volatile items like food and energy from the Consumer Price Index (CPI) or Personal Consumption Expenditures (PCE) index. This approach was introduced by Robert J. Gordon in 1975 and later formalized by Otto Eckstein in 1981. According to economic theory historian Mark A. Wynne, Eckstein was the first to propose a formal definition of core inflation as the “trend rate of increase of the price of aggregate supply.”
Alternative Methods for Core Inflation Measurement
Several alternative methods have been proposed to address potential shortcomings of the traditional approach. These methods aim to separate the “signal” (underlying trend) from the “noise” (temporary fluctuations) in price data.
- Trimming: This method removes a certain percentage of the highest and lowest price changes from the index calculation, resulting in a more robust measure.
- Moving Average: This approach uses the average price level over a specific period to smooth out short-term fluctuations.
- Median CPI and Median PCE: These methods focus on the price change experienced by the “middle” consumer by calculating the median price change across all goods and services.
Choosing the Right Core Inflation Measure
The choice of core inflation measure depends on the specific analysis and desired level of volatility filtering. Each method has its advantages and limitations, and policymakers and economists often consider multiple measures to gain a comprehensive understanding of inflation dynamics.