Understanding ‘Core’ Inflation

by George Hatjoullis

The US CPI data for December 2014 have just been released. The all items CPI index fell by 0.4% on the previous month and rose by 0.8% on the previous year. A CPI index that excludes food and energy prices, the so-called ‘core’ inflation rate was unchanged on the month and rose by 1.6% on the year. There is no inflation problem in the US but there might be a deflation problem emerging. One of the concerns is the rather simplistic notion of ‘core’ inflation being promoted by these data.

My first encounter with the concept of core inflation dates back to 1981 and a book by Professor Otto Eckstein entitled Core Inflation (Prentice Hall). Eckstein developed a theory of core inflation. The core rate is the trend increase in the cost of factors of production and is sourced in the long-term inflation expectations of households and businesses. His theory of how these expectations are formed is essentially a distributed lag model. This just means that expectations are formed by past experience with the most recent experiences having the greatest weight. It was meant to stand in contrast, I believe, to rational expectations. The distributed lag model may be simplistic but experience is important. Measuring inflation expectations is more an art than a science (in my view) so one can see that simply excluding food and energy is open to question.

The logic (in Eckstein’s book) behind excluding food and energy is not so much that they are volatile but exogenous to the economic system. He was writing in the wake of the OPEC oil shocks which saw oil prices manipulated higher. Food prices also have a huge weather and natural disaster element that is exogenous to the economy. Exogenous simply means, in this context, having influence on the economy but not being influenced by it. If oil and food prices are being influenced by the economy then they are not exogenous but endogenous and thus potentially an element of core inflation.

On August 21, 2014 I published a blog entitled “The oil price, geopolitics and growth”. You can find it under the Economics category. The thrust of this blog was that the oil price was signalling a slowdown in global growth. It was an endogenous outcome and in the absence of some growth stimulus was likely to continue. The Brent crude price was still above 100 when I published. Excluding energy from the CPI seems inappropriate if it is a symptom of slow global growth especially if households and businesses recognise it to be such. The oil price will influence inflation expectations much more quickly than a distributed lag model would suggest because rational agents recognise the cause and context of the oil price decline and incorporate it into expectations. Food is more complicated but, in the UK at least, a change in the distribution network is putting structural pressure on prices. This too is part of core inflation, or more precisely, disinflation.

The real issue however is nominal wages. Despite substantial gains in employment the trend rate of growth in this important factor price has been very slow-growing. This has been the case for some time so even in a distributed lag expectations formation model one would expect inflation expectations to be dipping and thus true core inflation to be weakening. If measures of inflation expectations are lagging I fear it is because they are poor measures. The all items CPI is weak because wages are not rising fast and aggregate demand is weak. Excluding food and energy is misleading in this context as energy at least is weak because of global demand. The US has achieved substantial employment and GDP growth since the crisis. It has kept interest rates low and until very recently has an aggressive QE programme. Yet disinflation is still evident. This is a cause for concern and needs to be noted.

In part the US is importing global deflation via the strong US Dollar. That the US economy cannot generate price stability, and export it, is worrying for the US and the rest of the world. The signal to the Federal reserve is clear. Raising rates is very dangerous and they should be careful not to exacerbate a very fragile global deflation environment. The big mistake would be a premature rate hike and it may help avoid this if the simplistic view of core inflation that has taken hold is re-examined. Core inflation is weaker than the ex food and energy CPI would imply.