Relevance of core inflation as an indicator of underlying inflation in the economy and as a policy tool

Abstract

Inflation control is one of the critical macroeconomic goals for any government. There is always a lag observed between implementing a monetary policy and the resultant price changes in an economy. If the policy rates are set too high then growth of the economy is stifled. On the other hand, if the policy rates are too liberal then it leads to the other beast of overheating. Thus, policymakers face a daunting task of gauging the accurate state of an economy and basing their policy decision on these judgements. Often, there are several price level indicators that are measured periodically in any economy. The need for a stable and less volatile indicator thus becomes crucial as a policy tool for the central bank. Consumer Price Index has been historically reported since 1913 in the USA. However, the volatility of this measure has caused economists and policymakers towards a more stable and credible indicator. The core inflation is once such indicator that isolates the effect of fuel and food from the CPI data. Food and fuel contribute the most towards volatility in the CPI and hence it is believed that their exclusion results in a more robust indicator. Core inflation can thus be used to measure the inflation inertia in an economy. However, there are several other robust indicators that are available for the policymakers. These include Core CPI, Core PCE, trimmed mean, weighted median, etc. Thus, there is a need to identify the most relevant price indicator for the policymaker. In this paper, we have tried to cover various aspects of measuring price changes in an economy. Starting from CPI figures, we have uncovered the various facets which are desirable from a price change measure. Core inflation has been compared to CPI on various parameters that make up a robust inflation measure. Various measures of core inflation have also been illustrated and compared. We have also worked on the hypothesis of finding a mathematical relationship that can help policymakers set the policy rates. The results have been robust and the research can be used to conduct further investigations.