Blog #2 The relevance of core inflation in policymaking

Although ongoing interest rate increases have been made to curb inflation, the effort appears to be in vain. This year, in most economies, food costs and the core inflation rate are higher and sticker than forecast.

In the U.S., year-on-year, headline inflation expanded by 4.9% in April, and core inflation grew by 5.5%, which was 0.6 percentage points higher than headline (refers Table 1). The food price was up by 7.7% year-on-year in the month.

In policymaking, central banks generally make use more of core inflation for forecasting and decision-making. The logic is simple: exclude volatile components of the price index, for instance, food and energy, to yield more accurate policy insights.

Volatility can be somehow put aside in policymaking because transitory increases in prices could have just vanished in a few months, just like what occurs with energy inflation presently.

Inflation would revert to its underlying trend rate and remain basically unchanged even if no monetary policy is taken against it. As shown in Table 1, up to now, headline inflation has fallen 4.2 percentage points from June 2022, which is the highest record inflation rate since last year. However, core inflation was down by only 0.4 percentage points over the same period.

As the volatile rise in prices, for instance, in energy prices, is not likely to lead to a rise in long-run inflation expectations (refers Figure 1), central banks have reason to not overreact to the temporary rise in headline inflation to stabilize price levels.

As the central banks respond rather to curb core inflation, which is relatively lower, the present rate hikes are considered moderate and are not tightened excessively, which can avoid an unnecessary decline in employment, at least theoretically.

Despite Jerome Powell’s signal that there will be a slowdown in rate hikes in the coming months, the Federal Reserve has the responsibility to return the inflation rate to its targeted rate of 2–3%.

To keep inflation under control, the rate hikes might continue as long as core inflation is still stubbornly sticky. One thing to note is that although food prices are going down, the price shocks seem to have lingered longer than one might have first thought.

The longer the period of high food inflation persists, the greater the risk of second-round effects of the food price shock. The public begins to build continued higher inflation into their expectations.

Given its wide economic interconnectedness, food price shock could be a force to drive out second-round inflation through their input-output linkages to different economic sectors, for instance food processing, fertilizer, and restaurants.

Ignoring food price stickiness could lead to misleading information about what is happening to the underlying rate of overall inflation. Therefore, food price shocks could be embedded in inflation expectations and generate valid inflation-controlling impacts.