How core inflation impacts our lives

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

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.

Inflation might have peaked in March, but it will likely remain sticky at elevated levels for the balance of the year.Silvia Dall’Angelo, Federated Hermes

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. 

Central banks are hoping that by putting interest rates up, the level of aggregate demand in the economy will fall, which would reduce the demand for labour in the economy, and put downward pressure on wages.

Similarly, chancellor Rishi Sunak is under pressure from his political opponents, and some of his political allies, to take action to boost economic growth and alleviate pressure on household spending.

The latest indications from the government is that such measures may be introduced in the summer, but the government is waiting to see whether the volatile piece of the inflation number persists and leads to core inflation.

One concern fiscal policymakers may have is that the energy price inflation begins to wane in the autumn, just as the impact of higher government spending is being felt in the economy, effectively swapping the short-term energy-price-led inflation for inflation from the government spending side. 

 

Conversely, by not increasing spending now, the government are (whether intending to or not) causing people to reduce their spending and so may be pushing down demand in the economy, placing a lid on the core inflation number.

If energy prices are going to subside later in the year anyway, then measures taken now to address higher inflation are unnecessary, and are in fact serving only to reduce economic growth now.

Commenting on the US core inflation picture, Silvia Dall’Angelo, senior economist at Federated Hermes, says the core inflation numbers we are seeing now do not yet fully reflect the impact of the war in Ukraine.

She says: “As widely expected, US headline CPI inflation declined slightly to 8.3 per cent in April, from 8.5 per cent in March. However, details did little to assuage concerns about underlying inflationary trends, showing price gains remained pervasive and sustained on a sequential basis.

"Indeed, while energy prices moderated in April, core prices (excluding energy and food) accelerated to a 0.6 per cent monthly increase, compared to 0.3 per cent in March. As a result, core inflation edged down by less than expected in April – with the decline entirely due to favourable base effects.

"Inflation might have peaked in March, but it will likely remain sticky at elevated levels for the balance of the year, reflecting considerable external and domestic price pressures that are still in the pipeline."

Dall’Angelo adds: "The full impact from the increase in commodity prices due to the conflict in Ukraine has still to make its way through into consumer prices, with food and transportation services likely to record further large increases in coming months.

"In addition, the labour market is tight, meaning that wage pressures will remain sustained, so higher labour costs will put upward pressure on consumer prices."

Headline acts? 

Dall’Angelo says the risk is that the impact of the war in Ukraine and exit from the pandemic restrictions cause a structural change in the level of inflation in the economy. 

But Keith Wade, chief economist at Schroders, says we may already have the answer to that quandary.

He calculates that only around a quarter of the higher inflation we are seeing is from energy and food costs, with the rest coming from the factors that impact core inflation. 

The impact of this may already be felt, with the latest UK GDP numbers showing the economy contracted in March, and in the US data showed it contracted in the first quarter of this year. 

The picture in the UK is broadly similar to the rest of the world; headline inflation is actually higher in the US and Eurozone than in the UK, this may be because the US sent cheques to people during the pandemic, so the level of savings among households may be higher.

In the Eurozone, the pandemic restrictions continued for a longer period of time than in the UK, so its economies are at an earlier stage of the re-opening cycle.

But the differences between the headline inflation levels in the three regions is quite small, and it will be the core inflation number that determines the path of monetary policy, and possibly economic growth, in the months and years to come. 

David Thorpe is special projects editor of FTAdviser