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The Inflation Divide

Not all inflation is created equal

Inflation has been surprisingly persistent in 2023 despite central banks’ best efforts to combat it. When reading headlines and news blurbs, it can be helpful to know whether the numbers you are reading are truly relevant. That is, not all inflation figures are created equal.

Inflation is a measure of the rate at which the general level of prices of goods and services in an economy is increasing over a given period. It is an important economic indicator that helps policymakers make decisions about monetary policy, fiscal policy, and business strategies. However, not all inflation is created equal, and there are two types of inflation that are particularly important to understand: core inflation and general inflation.

Core vs General

Core inflation is a measure of the change in the prices of goods and services in an economy, excluding certain items that are particularly volatile or subject to seasonal fluctuations, such as food and energy. The rationale for excluding these items is that they can have a temporary impact on inflation and do not necessarily reflect the underlying trend in price changes. Core inflation provides a more stable and reliable measure of inflation trends and is therefore considered a more important indicator of overall inflationary pressures.

On the other hand, general inflation measures the overall increase in prices of goods and services, including the prices of food and energy. General inflation tends to be more volatile than core inflation because it is influenced by various factors, including changes in supply and demand, monetary policy, and geopolitical events. General inflation is often used as a headline inflation rate because it is more visible and easier to understand, but it can be misleading as it includes temporary fluctuations in prices.

The importance of core inflation versus general inflation depends on the specific context and the policy goals that policymakers are trying to achieve. In general, core inflation is considered a more important measure of inflationary pressures because it provides a more stable and reliable measure of long-term trends. Policymakers use core inflation to set monetary policy, which can influence the overall level of economic activity and the level of employment. For example, the Federal Reserve in the United States uses a measure of core inflation called the Personal Consumption Expenditures (PCE) price index to set its target for the federal funds rate, which is the interest rate that banks charge each other for overnight loans. The Fed aims to keep inflation at a stable rate of around 2 percent per year over the long run, which it believes is the optimal level for promoting economic growth and full employment.

Broader, not better

In contrast, general inflation is often used to measure the impact of specific events or policy changes on the overall level of prices. For example, if the price of oil spikes due to geopolitical tensions or supply disruptions, this can lead to a temporary increase in general inflation, which may not reflect underlying inflationary pressures. Similarly, changes in tax policies or subsidies can affect the prices of certain goods and services, which can cause temporary fluctuations in general inflation. One of the main benefits of using core inflation instead of general inflation is that it helps policymakers distinguish between temporary and persistent inflationary pressures. By excluding volatile items like food and energy, core inflation provides a more accurate measure of the underlying trend in price changes, which can help policymakers make more informed decisions about monetary policy. If core inflation is high and rising, this may signal that there are underlying inflationary pressures that need to be addressed through tighter monetary policy, such as raising interest rates.