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After NBS Release: What is Core Inflation, CPI, Base Effect

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Tuesday, March 14, 2017 3.45 PM / Investopedia   

 

Core inflation reflects the long-term trend in a particular price level. It is a measure of inflation that excludes certain items that face volatile price movements because in finding out the legitimate long run inflation, short-term price volatility and transitory changes in price must be removed. Core inflation is most often calculated using the consumer price index (CPI), which eliminates products — usually those in the energy and food sectors — that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation.

 

Breaking Down 'Core Inflation'

Other methods of calculation include the outliers method, which removes the products that have had the largest price changes. Core inflation is thought to be an indicator of underlying long-term inflation. 

Core inflation is calculated by taking the CPI or the core personal consumption expenditures (PCE) index. The calculation for core inflation excludes food and energy prices, most notably oil and gas, because food and energy prices fluctuate based on quick-changing emotions of commodity traders and speculators around the globe rather than the changes in economic supply and demand.

In January 2012, the Federal Reserve declared that it would rather use the PCE index than CPI since PCE provided inflation trends that are less affected by short-term price changes.

 

To get underlying trends that are not affected by short-term price movements caused by traders and speculators, the Bureau of Economic Administration (BEA) calculates the change of prices by using existing gross domestic product data. It also adds in the monthly Retail Survey data and compares them with the consumer prices with the data provided by the CPI. These additions remove data irregularities, providing detailed long-term trends.

 

The Importance of Core Inflation

It is important to measure core inflation because it reflects the relationship between the price of goods and services and the price of consumers' general income. If goods and services increase over time but the income of consumers do not, consumers will have weaker buying power since the value of their money decreases in comparison to the value of basic goods and services. However, if inflation happens to consumers' income and nothing changes with the prices of goods and services, consumers will have better buying power and can afford more of the same goods and services. When consumers' stock portfolio or home price increase, asset inflation happens, which provides more money for the consumer as well.

 

 

Definition of 'Base Effect'

The consequence of abnormally high or low levels of inflation in a previous month distorting headline inflation numbers for the most recent month. A base effect can make it difficult to accurately assess inflation levels over time. It wears off over time if inflation levels are relatively constant.

 

Breaking Down 'Base Effect'

Inflation is calculated from a base year in which a price index is assigned the number 100. For example, if the price index in 2010 was 100 and the price index in 2011 rose to 110, the inflation rate would be 10%. If the price index rose to 115 in 2012, what would be the best way to assess inflation? On the one hand, prices have only risen 5% over the previous year, but they've risen 15% since 2010. The high inflation rate in 2011 makes the inflation rate in 2012 look relatively small and doesn't really provide an accurate picture of the level of price increases consumers are experiencing. This distortion is the base effect.
 

What is the 'Consumer Price Index - CPI'

The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living; the CPI is one of the most frequently used statistics for identifying periods of inflation or deflation.

 

Breaking Down 'Consumer Price Index - CPI'

The U.S. Bureau of Labor Statistics reports the CPI on a monthly basis. Two types of CPIs are reported each time. The CPI-W measures the Consumer Price Index for Urban Wage Earners and Clerical Workers. The CPI-U is the Consumer Price Index for Urban Consumers. It accounts for 89% of the U.S. population and is the better representation of the general public. The CPI-W is a subset that covers 28% of the U.S. population.

 

The CPI is used by the president, Congress and Federal Reserve Board to formulate fiscal policies based on the monthly findings and how inflation or deflation is presented. The CPI rate is expected to be 2% or under by the U.S. Department of Labor. If this inflation measure hits above the 2% level, borrowing rates may be raised to help fight off inflation. Sometimes, such as in 2014, the CPI rising above 2% is not enough to get rates raised. Other inflation gauges are also used to decide the level of inflation.

 

What Is in the CPI?

The CPI statistics cover professionals, self-employed, poor, unemployed and retired people in the country. People not included in the report are nonmetro populations, farm families, armed forces, and people serving in prison and those in mental hospitals.

 

The CPI represents the cost of a basket of goods and services across the country on a monthly basis. Those goods and services are broken into eight major groups:

• Food and beverages

• Housing

• Apparel

• Transportation

• Medical care

• Recreation

• Education and communication

• Other goods and services

 

CPI Regional Data

The Bureau of Labor Statistics also breaks down the CPI based on regions. Each month, the report is broken out into the four major Census regions: Northeast, Midwest, South and West. Three major metro areas are also broken out each month. The regions are Chicago-Gary-Kenosha, Los Angeles-Riverside-Orange County and New York-Northern NJ-Long Island.

Along with the regional information provided each month, the Bureau of Labor Statistics also publishes reports for 11 additional metro areas every other month and an additional 13 metro areas semi-annually. These reports cover areas with large populations and represent a particular region subset.

Related Footnotes 

1.    To learn how to take advantage of inflation, read How to Profit From Inflation and The Consumer Price Index: A Friend to Investors 

2.      Read more: Core Inflation Definition | Investopedia

3.      Read more: Base Effect Definition | Investopedia

4. Read more: Consumer Price Index - CPI Definition | Investopedia

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