Core Inflation

| Thu Aug. 28, 2008 5:43 PM EDT

CORE INFLATION....Why does the Fed rely on a "core" inflation rate — one that excludes food and energy costs — when it sets monetary policy? Are they trying to pretend that food and energy, items that are more important to the middle class than to the rich, don't matter? Mark Thoma explains:

If the question is "what is today's inflation rate," the total inflation rate is the best measure. It's intended to measure the cost of living and there's no reason at all to strip anything out. It's only when we ask different questions that different measures are used.

Core inflation, it turns out, (a) does a better job of forecasting future inflation, (b) does a better job of estimating whether inflation is currently rising or falling, and (c) is the inflation target that best stabilizes the economy.

The core inflation rate you see in the news, the one that strips out food and energy, should be though of as a short-hand, quick measure of all three of these concepts. But in each case the Fed uses measures (formally or informally) designed to best satisfy these three functions. For example, when it forecasts future inflation, it uses a different concept of core inflation than it uses in setting policy.

In other words: no, the Fed isn't trying to pretend that food and energy inflation aren't important. They focus on core inflation because it's a better input to the technical models they use to guide monetary policy. Read the whole thing for the full explanation.