Happy Wednesday! What do we even mean when we say “inflation”?

IN ACTION

“… the goal overall is headline inflation, because that’s what people experience. People don’t experience core inflation; they experience inflation, and that includes food and energy costs. So that’s the overall goal.” - Chair Powell’s Press Conference (December 18, 2024)

THE BASICS

Core inflation addresses a limitation in our most widely watched inflation measures. To understand it better, consider this hypothetical: if you were tasked with determining whether the Fed is controlling inflation, would you exclude prices beyond its control? Core inflation provides a more accurate measure of underlying, long-term inflation trends by excluding volatile items like food and energy.

WHY IT MATTERS

The two primary inflation measures tracked in the US are the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) price index. Although they differ in methodology, both include food and energy in their calculations. Core inflation allows policymakers to more accurately assess inflation trends tied to economic conditions and policy actions by eliminating volatile items such as food and energy, which often experience short-term fluctuations due to factors unrelated to the overall economy (weather, geopolitical events, etc.). By excluding these components, core inflation (whether from CPI or PCE) provides a clearer assessment of how the Fed is tracking towards its target inflation rate.

This week’s “In Action” quote highlights an important issue with core inflation. While a positive core inflation reading can suggest a stable price outlook and progress towards the central bank’s goals, it does not reflect the full impact on consumer spending. Shocks to food and energy prices can profoundly impact purchasing power, so it’s important to recognize, as Chair Powell did in his press conference, that consumers are impacted by all inflation.

2025 AND BEYOND

The core PCE price index rose to 2.8% in February, a 0.4% month-over-month increase, exceeding analysts’ forecasts. The higher-than-anticipated inflation reading has raised doubts about market expectations for 2-3 rate cuts later this year, as the Fed may hold rates steady if inflation remains elevated. The Federal Reserve will continue to use core inflation as a key indicator of long-term inflation trends.

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