Core Inflation refers to the change in the cost of goods and services without calculating the important categories of food and energy. The U.S. federal government believes this to be the most accurate means of figuring up true inflationary trends. They claim that both energy products and food components are priced too volatilely to be a part of the core inflation calculation and figure. This is because they constantly change so rapidly that they interfere with inflation readings.
The reason for this is that they are subject to the whims of the traders on the various commodity market exchanges. The majority of core food products like beef, pork, wheat, orange juice, and more and energy products such as oil, natural gas, and gasoline trade each and every week day all throughout the day.
As an example, traders of commodities will likely bid up the prices of oil and its derivative products when they believe its supplies will diminish or if they feel that demand will outpace supplies. It could be that a strike will interrupt production and oil supplies from Nigeria, Venezuela, or Angola. Because of this fear, traders will purchase oil at the prices today and hope to sell it for a higher amount at the anticipated greater prices tomorrow or next week.
That is all that it really takes to radically increase the price of oil. Should the strike wrap up quickly, then the oil prices will plunge when traders suddenly all sell out of their positions. This is why both energy and food prices depend on rapidly changing human emotions rather than real changes to underlying forces of supply and demand. Between this and the inelastic demand of food and energy which people simply have to possess in order to live, these commodities rise and fall crazily sometimes.
Consider how gasoline prices will change when their primary input oil does. Yet as people require gas to travel to school and work, they cannot delay their purchases and wait for prices to decline. Food prices also vary according to gasoline and oil prices as they are shipped by truck throughout the United States. In truth, most foods on your dinner plate have more frequent flyer miles than you ever dreamed of acquiring.
The Fed has a few tools to deal with higher than desired core inflation. The problem comes with their tools needing time to take effect on the broader economy. This might mean as much as from six to 18 months before changes to the Fed Funds rate will show a meaningful impact on the inflation rate in the U.S. As the Fed Funds rate goes higher, so will the bank loans and mortgage rates. Credit will tighten and slow economic growth. Corporations find themselves lowering their core prices in order to keep selling merchandise. This lowers inflation as it finally all feeds through to the economy.
The Federal Reserve targets inflation with their policies. They promise to not take action when the core inflation rate remains at two percent or lower. Consider a real world example. Inflation has a tendency to creep higher throughout the summer as people go on vacations. The Fed does not wish to raise rates each summer though, which would force them to proportionally lower them again in the fall.
Rather, they wait and see if such summer increases boost the prices of the goods and services ex food and energy permanently. Yet ultimately higher food and gas prices force up the prices of all other goods and services if they remain elevated for long. This is why the Federal Reserve will also consider the headline inflation rate, which is the opposite of the core inflation rate. This broader measure of inflation considers food and energy prices alongside all other goods and services.
The core inflation rate can be measured via the Core Price Index, or core CPI, as well as the core Personal Consumption Expenditures price index, or core PCE price index.