The Federal Reserve (Fed) is mandated to keep inflation low and stable, and alters interest rates in order to do so. In recent years, the Fed has focused attention on the core rate of inflation, a measure of inflation that excludes food and energy prices, in explanations of its policy decisions. When core inflation approached 3% in 2006, Chairman Bernanke said that it had "reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability...." This report defines core inflation, reviews recent trends, and analyzes the advantages and drawbacks of using core inflation. When food and energy prices are omitted from the CPI, the remaining basket is commonly referred to as the core CPI . When Should Core Inflation Be Used? Headline inflation often does not have good predictive power over short-time periods because food and energy prices are so volatile. Policymakers are concerned with future inflation because of lags between a change in policy and its effect on the economy. Relying on core inflation for policymaking has its drawbacks, however. This scenario occurred in the 1970s where rising energy prices resulted in a rise in total inflation. In scenarios like this one, a focus on core inflation could forestall a needed policy change until it is too late. In fact, that study found food prices to be a better predictor of future inflation than any other measure, including core inflation.
Inflation measures the rate of change in all prices. Maintaining low and stable inflation is one of the primary goals of macroeconomic policy. But how should inflation be measured? Policymakers, particularly at the Federal Reserve, often refer to core inflation in their policy decisions. Core inflation is commonly defined as a measure of inflation that omits changes in food and energy prices. Some policymakers prefer to use core inflation to predict future overall inflation because food and energy price volatility makes it difficult to discern trends from the overall inflation rate. A drawback of an over-reliance on core inflation, however, is that an extended period of rapidly rising food or energy prices could cause all other prices to accelerate. A focus on core may cause policymakers to fail to react to such a rise in inflation until it is too late. This scenario may have occurred recently. Many economists are concerned that rapid increases in food and energy prices are now pushing overall inflation to uncomfortably high levels. Furthermore, several studies have failed to find core inflation to be a good forecaster of future inflation, casting doubt on the very rationale for relying on it.