What is Core Inflation: Inclusions, Causes & Rate?

Since economies are prone to receiving supply shocks from time to time, it causes considerable variations in prices of certain commodities.

This is why many central banks use the term core inflation to refer to this scenario accurately. Here is a detailed guide on what core inflation is and its detailed components.

Core inflation calculates long-run inflation and indicates changes in the prices of goods and services. However, it does not include the costs of commodities from the food and energy sector. Thus, the difference in the price change of goods and services and food and oil indicates the core inflation rate in an economy.

This is because the costs of products from these two sectors are volatile. Demand for these two essential commodities does not change that much, even if the prices increase. Including these in the calculation of inflation can reduce the accuracy measure of the severity of inflation.

Let us take a look at what is included in core inflation and the reasons behind the occurrence.

In recent years, the core inflation rate has been persistent in India. Although it is still lower than the overall inflation rate, which is 6%, it is still a significant rate. This has caused a considerable increase in the cost of living.

There are several factors that put pressure on the consumer price index (CPI) which affects India's core inflation rate.

• High Cost of Credit: The interest rates in India are relatively high, which can increase the costs of services and commodities people finance through borrowing.
• Population Growth: Rapidly growing population in India exerts pressure on its resources. This is a reason that can lead to an increase in the prices of goods and services.
• Regulatory and Administrative Barriers: Bureaucratic and other such regulatory barriers can contribute to high prices of products and services. This is since it might limit supplies of certain goods through the introduction of trade barriers of policies.
• Fluctuations in Exchange Rate: When there are differences in the exchange rate of goods, it can affect the prices of imported goods. This can lead to alterations in the overall inflation rate.
• Limited Supply of Goods: There are specific scenarios where certain commodities and services are short in supply. This often leads to an increase in demand and, thus increase in cost.
• Food and Fuel Costs: Since food items and fuel prices are volatile, they can significantly impact the inflation rate. However, these items are excluded from the overall measurement to provide a more stable and consistent calculation of price rise.

Now that you know what core inflation is, here is how it works.

Core inflation has a significant part in impacting economies gradually. Here are 2 points about how it works and its effects on the prices of goods and services:

• When core inflation is around 1-2%, it stimulates the growth of the economy since consumers start purchasing services and commodities.
• However, if the rate becomes too high and the people's salaries do not increase, it may increase the prices of essential goods. As a result, the economy will suffer since some sectors will see growth while some industries will suffer heavy losses.

Core inflation has some severe effects on the growth of an economy.

Persistent core inflation in an economy presents several challenges. Here are a few of the problems that it poses:

• Reduction in Purchasing Capacity - Inflation makes even the most basic goods unaffordable to ordinary people. This reduces the purchasing power of consumers.
• Economic Slowdown - Businesses will be hesitant to invest in an environment of financial instability where the prices are constantly rising. This will slow down the growth of the economy.
• Rise in Inequality - Low-income households are the worst affected by inflation. Since people with meagre earnings will not have the means to shield themselves against the rising prices, they will face additional financial challenges.
• Difficulty in Managing Monetary Policies - Governments and central banks' goal in core inflation is to curb inflation alongside boosting economic growth. In scenarios like these, managing financial policies may be a challenging task for them.

Although core inflation is detrimental to an economy, calculating it is crucial for several reasons.

Core inflation is crucial since measuring it determines the relationship between the consumer's income and the prices of goods and services. If the consumer's income rises and the costs of commodities remain the same, it will give them more purchasing power. Also, this wage growth can lead to asset inflation, which can benefit consumers.

Similarly, in the reverse scenario, if the costs rise and the wages of people in the economy remain unchanged, their purchasing capacity will decrease. Due to inflation, income will decrease compared to the prices of everyday goods and services.

Here are 2 key highlights of the benefits of core inflation measurement:

• It provides an accurate insight into the inflation trends inside an economy.
• Within an economy, core inflation indicates long-term inflation rates.

Although there are several different methods of measuring core inflation, 2 metrics are frequently used:

• Consumer price index (CPI)
• Core personal consumption expenditures (PCE).

The standard metrics that are used for the calculation of core inflation are- the consumer price index (CPI) and the core personal consumption expenditures (PCE) price index.

The Federal Reserve uses the PCE index rather than CPI since price changes influence the PCE inflation trends in the short term. PCE is much more inclusive than CPI, less volatile and better indicates the underlying inflation rates.

However, in India, the CPI and wholesale price index (WPI) is used to measure core inflation.

Inflation is a phenomenon that robs away an economy's growth potential over time. Since the concept of inflation is a part of core inflation, it is essential to employ measures to prevent inflation, which will further reduce it.