Vantage Point: Volatility  

How core inflation impacts our lives

How core inflation impacts our lives
(Anthony Delanoix/Unsplash)

Few data points are watched more closely now than the rate of inflation, both in the UK and globally, as investors and consumers search for signs that the cost of living crisis gripping markets could be about to abate.

But when the inflation numbers are published on both sides of the pond, two numbers emerge; the first is the headline rate, which is the number that gets most of the attention, and the second is the core inflation rate, which strips out the impact of the most volatile items from the proverbial basket of good, namely food and fuel. 

The most recent rate of headline inflation in the UK in March 2022 was 7 per cent, and core inflation rate was 5.7 per cent. 

In the US, headline inflation reached 8.3 per cent in April, and core inflation was 6.3 per cent.  

An obvious question to ask is what is the value of extracting the two largest and most important elements of an individual's wallet from the calculations? 

The answer is that core inflation is used by policymakers as a signal for what the longer-term inflationary trend in an economy is, on the assumption that the volatile items will eventually normalise. 

So a major driver of inflation around the globe right now is the higher energy prices resulting from the war on Ukraine – this is part of the volatile non-core inflation mix.

Food prices are impacted by supply shortages as a result of the pandemic.

Both of those items in the inflation basket are acutely volatile.

Central banks are putting interest rates up, not because they believe that tighter monetary policy can make the oil price go down, but because they are trying to prevent the volatile and likely short-term component of the inflation basket converting into core inflation.

The most obvious way this could happen would be if people responded to the higher food and fuel prices by demanding wage increases in line with the headline inflation rate, which could then bring the core inflation rate closer to the headline inflation rate, causing inflation to become structurally higher, rather than merely cyclically higher. 

For example, if wages began to rise by the same level as headline inflation, but then headline inflation falls because, for example, oil and commodity prices fall, then the most volatile bit of inflation would be falling, but the core number would be rising, entrenching the higher number in the economy for a longer period of time.

There is historic precedent for this. The Yom Kippur war in 1973 caused a spike in the oil price, which created global supply-side inflation at the headline level. 

Oiling the wheels

The oil price shock was actually comparatively short-lived, but the headline inflation that resulted from the supply shock fed through to the rest of the economy via higher wages, creating stagflation that lasted until the 1980s.