Inflation: Core vs. Headline

Inflation: Core vs. Headline
Marc Labonte
Specialist in Macroeconomic Policy
Government and Finance Division
Summary
Inflation measures the rate of change in all prices. Maintaining low and stable
inflation is one of the primary goals of macroeconomic policy. But how should inflation
be measured? Policymakers, particularly at the Federal Reserve, often refer to core
inflation in their policy decisions. Core inflation is commonly defined as a measure of
inflation that omits changes in food and energy prices. Some policymakers prefer to use
core inflation to predict future overall inflation because food and energy price volatility
makes it difficult to discern trends from the overall inflation rate. A drawback of an
over-reliance on core inflation, however, is that an extended period of rapidly rising food
or energy prices could cause all other prices to accelerate. A focus on core may cause
policymakers to fail to react to such a rise in inflation until it is too late. This scenario
may have occurred recently. Many economists are concerned that rapid increases in
food and energy prices are now pushing overall inflation to uncomfortably high levels.
Furthermore, several studies have failed to find core inflation to be a good forecaster of
future inflation, casting doubt on the very rationale for relying on it.
Introduction
Inflation, the general rise in the prices of goods and services, is important to¹
policymakers for several reasons. First, rising inflation is unpopular with the public, in
part because some households are more adversely affected by inflation than others.
Second, high or rising inflation can reduce productivity by distorting price signals, so that
it is hard for businesses to tell if prices are changing in relative terms, and by individuals
wasting resources in order to maintain the purchasing power of their wealth. Finally,
inflation plays a key role in macroeonomic stabilization policy. Changes in inflation often
indicate changes in the business cycle — rising inflation is often a sign that the economy
is overheating and falling inflation is a sign that the economy is sluggish. The Federal

¹ For more information, see CRS Report RL30344, Inflation: Causes, Costs, and Current Status,
by Marc Labonte and Gail Makinen.

Reserve (Fed) is mandated to keep inflation low and stable, and alters interest rates in
order to do so.²
In recent years, the Fed has focused attention on the core rate of inflation, a measure
of inflation that excludes food and energy prices, in explanations of its policy decisions.
For example, in July 2007, the third sentence of the 10-sentence Federal Open Market
Committee statement summarizing the committee’s policy decision read, “Readings on
core inflation have improved modestly in recent months.” In Fed Chairman Ben
Bernanke’s July 2007 testimony to Congress, he stated that “Food and energy prices tend
to be quite volatile, so that, looking forward, core inflation...may be a better gauge than
overall inflation of underlying inflation trends.” When core inflation approached 3% in
2006, Chairman Bernanke said that it had “reached a level that, if sustained, would be at
or above the upper end of the range that many economists, including myself, would
consider consistent with price stability....”³ This report defines core inflation, reviews
recent trends, and analyzes the advantages and drawbacks of using core inflation.
Definition
No official measure of “inflation” exists. Inflation is measured as the percent change
in a price index. Several indices track price changes, with each data series measuring
something different. The most commonly cited measure of inflation is the percent change
in the consumer price index (CPI).⁴ This index measures the price of a basket of
consumer goods and services that is representative of overall consumer purchases in urban
areas. When food and energy prices are omitted from the CPI, the remaining basket is
commonly referred to as the core CPI. The overall measure of CPI, which includes food
and energy, is often referred to as the headline CPI. Another common measure of
inflation is the percent change in the GDP (gross domestic product) price deflator, which
is used to transform nominal GDP into real GDP. Since the GDP deflator is based on the
prices of all goods and services in the economy, it is a broader measure of inflation than
the CPI. A subset of the GDP deflator that is conceptually similar to the CPI, but includes
more items and areas, is the personal consumption expenditures (PCE) price deflator; for
technical reasons, the Fed sometimes prefers this measure to the CPI in their analyses.
Core measures of the GDP and PCE deflators are also available.
Conceptually, core inflation could be any measure of inflation that attempts to strip
out price volatility, but the most common definition of core strips out only two
particularly volatile categories of goods, food and energy. The four most volatile items
in the CPI are all food or energy products.⁵ The standard deviation of energy prices is

² For more information, see CRS Report RL30354, Monetary Policy and the Federal Reserve,
by Marc Labonte and Gail Makinen.
³ Chairman Ben S. Bernanke, “Panel Discussion: Comments on the Outlook for the U.S.
Economy and Monetary Policy,” at the International Monetary Conference, Washington, DC,
June 5, 2006.
⁴ For more information, see CRS Report RL30074, The Consumer Price Index: A Brief Overview,
by Brian W. Cashell.
⁵ Todd Clark, “Comparing Measures of Core Inflation,” Federal Reserve Bank of Kansas City,
(continued...)

estimated to be 12 times higher than overall inflation.⁶ Omitting food and energy prices
from the CPI is not a trivial modification — food and beverages accounted for 15% of the
headline CPI basket, and energy accounted for an additional 9% in 2006.
While excluding food from core inflation has become conventional, it may no longer
be warranted. The volatility of food has decreased significantly since the 1970s.⁷ Until
2007, the recent divergence between headline and core inflation was driven by energy
prices. In 2007, food prices rose rapidly — it is too soon to tell whether this development
marks a renewed period of persistent volatility. If food prices are no longer volatile, then
policymakers may be losing useful information by omitting them.
Recent Inflation Trends
In recent years, headline inflation has typically outpaced core inflation, as seen in
Figure 1, because of the rapid rise in energy prices. In 2007, headline inflation was also
driven up by a 3.9% increase in food prices. The difference between core and headline
has not always been trivial — from 2003 to 2006, core inflation was 0.9 percentage points
lower than headline. Considering that the Fed judges 2% inflation to be on the low side
and 3% inflation on the high side, the definition used in these years would have arguably
strongly colored their policy stance. The difference between core and headline inflation
over this period was overwhelmingly the result of energy prices, which rose by an average
of 12.8% a year as measured by the CPI.
Figure 1. Inflation Rate, 1998-2007

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
HeadlineCore
^Source:^B^u^r^eau^o^f^L^a^b^o^r^Statistics
⁵ (...continued)
Economic Review, 2002:2, p. 5. The four most volatile items are fuel oil, motor fuel, meats and
dairy products, and fruits and vegetables.
⁶ Seamus Smyth, “Why Care About Core?,” Goldman Sachs, U.S. Daily Financial Market
Comment, September 7, 2006.
⁷ William Gavin and Rachel Mandal, “Predicting Inflation: Food for Thought,” Federal Reserve
Bank of St. Louis, Regional Economist, January 2002.

When Should Headline Inflation Be Used?
When comparing purchasing power over two time periods, headline inflation is the
relevant measure. Comparisons over time of wages, wealth, rates of return, government
transfers such as Social Security payments, and so on should all use a headline measure
of inflation, because all of these concepts depend on a broad measure of inflation. For
example, adjusting household income by core inflation would not be useful since food and
energy consumption account for about one-quarter of average household expenditures.
Similarly, government programs and parts of the tax code that are adjusted for inflation
are based on headline inflation. Economic growth is also calculated by first adjusting
GDP by headline inflation.
When Should Core Inflation Be Used?
Core inflation is used by policymakers for the reason offered by Chairman Bernanke
in the introduction — policymakers are most concerned about the future path of inflation,
and current core inflation data may give better information than current headline data
about future headline inflation. Headline inflation often does not have good predictive
power over short-time periods because food and energy prices are so volatile. For
example, the monthly headline inflation rate varied between -6.3% and 7.5% in 2006 at
annualized rates, whereas the core rate varied between 1.2% and 3.6%.⁸ Policymakers are
concerned with future inflation because of lags between a change in policy and its effect
on the economy. In essence, it is already too late for policy to influence current inflation,
a policy change today can only affect future inflation.
Theoretically, short-term changes in inflation can be caused by the supply-side or
demand-side of the economy. When rising inflation is demand-driven, it means that
spending is growing too quickly in the overall economy, and production cannot keep pace.
This phenomenon is captured in the famous saying “too much money chasing too few
goods.” The Fed’s task is to counteract this by raising interest rates in order to reduce the
growth rate of interest-sensitive spending. Likewise, if spending is rising too slowly,
inflation will fall, which the Fed can counteract by reducing interest rates.
In the short run, the overall inflation rate can also be affected by sharp price changes
of individual goods caused by supply shocks. For example, bad weather can drive up
food prices or a reduction in the oil supply can drive up energy prices. Since these supply
shocks are temporary, they should not have any lasting effect on inflation (holding
aggregate spending constant), in which case they can be ignored by policymakers. In the
long run, price shocks on the supply side should cancel each other out (since, across all
goods, there will be an equal number of positive and negative surprises), and average
inflation should be completely demand driven.
Ideally, policymakers would like to be able to identify whether any change in
inflation was demand-driven or supply-driven. Unfortunately, there is no straightforward

⁸ Of course, volatility is lower over longer time horizons, so policymakers also judge inflationary
pressures by looking at, say, the 12-month change in inflation rather than the one-month change.
In 2006, the 12-month change in headline inflation varied between 1.3% to 4.3%, and 12-month
core inflation varied between 2.1% and 2.9%.

way to do this, so they have commonly used core inflation as a proxy for demand-driven
inflation, reasoning that food and energy are two sectors of the economy that are most
susceptible to supply shocks. Furthermore, policymakers are particularly concerned with
inflationary expectations, and a rising core rate may be a better sign than rising headline
that inflationary expectations have risen.
Relying on core inflation for policymaking has its drawbacks, however. There is no
inherent reason that changes in food and energy prices cannot be caused by changes in
aggregate demand. For example, rapid spending growth could push up energy prices if
supply does not rise in response. In fact, an argument has been made that a change in
aggregate demand would first show up in price changes of goods that have flexible
pricing, such as commodities that are traded on financial markets where prices change
continually to clear the market.⁹ Both energy and basic foodstuffs are traded on financial
markets, although the CPI measures final food and energy products, not basic
commodities.
Furthermore, a rise in the price of any one good need not lead to a change in inflation
if the prices of other goods fall to offset it. Technically, if a rise in one price leads to a
rise in overall inflation, it must be because of some accommodation on the Fed’s part
(because it did not raise interest rates enough to induce other prices to fall). Most
economists believe that some accommodation to relative price changes is desirable
because it reduces the volatility of economic growth, whereas zero accommodation could
lead to needless disruptions in economic activity. For example, Fed Governor Frederic
Mishkin used the Fed’s macro model of the U.S. economy to show that when the Fed
reacts to changes in headline inflation instead of core inflation, future inflation will be
slightly less volatile, but unemployment will be significantly more volatile.¹⁰ But if the
Fed accommodates a rise in the price of one good too much, then the price of all goods
could start rising. In other words, a rise in headline inflation could feed through to higher
core inflation. This scenario occurred in the 1970s where rising energy prices resulted in
a rise in total inflation.
In scenarios like this one, a focus on core inflation could forestall a needed policy
change until it is too late. Indeed, a case can be made today that more of a focus on
headline inflation would have avoided the persistent upward trend in core inflation that
has occurred from 2003 to 2007 and brought core inflation above the Fed’s self-defined
“comfort zone.” The weakness with the focus on core inflation is that when energy prices
rise continually for a period of several years, they no longer represent random price
fluctuations that offer no useful information about future inflation. As a result, too much
monetary policy accommodation may have taken place recently, causing the economy to
overheat. Future events will reveal if this is the case, or if the rise in core inflation can
be painlessly reversed without a recession.

⁹ Brian Motley, “Should Monetary Policy Focus on Core Inflation?,” Federal Reserve Bank of
San Francisco, Economic Letter, no. 97-11, April 1997.
¹⁰ Frederic Mishkin, “Headline versus Core Inflation in the Conduct of Monetary Policy,” speech
at the Business Cycles, International Transmission and Macroeconomic Policies Conference,
Montreal, Canada, October 20, 2007.

In the end, the question of what measure of inflation is best for policymaking is an
empirical one. One study found that “no core measure does an outstanding job
forecasting [headline] CPI inflation...we find no strong evidence to suggest that a selected
core measure will be able to retain its usefulness as a tool to forecast inflation for any
given period...”¹¹ Another study did not find a statistically significant relationship
between core inflation and future headline inflation, although the relationship becomes
significant when limited to a more recent time period.¹² Two other studies found that
headline inflation is a better predictor of future headline inflation than core inflation.¹³
An explanation for this finding is that during the past 10 years, changes in core inflation
have tended to lag behind changes in headline inflation as illustrated in Figure 1. One
study found that a core measure that excludes only energy was a better predictor of future
inflation from 1983 to 2001 than a measure excluding food and energy. In fact, that study
found food prices to be a better predictor of future inflation than any other measure,
including core inflation.¹⁴ Some studies suggest that there may be more sophisticated
measurements that are better gauges of underlying inflationary pressures than the standard
definition of core inflation.¹⁵ Core inflation has the advantage from a policy perspective,
however, of being transparent, whereas the more sophisticated measurements could be
hard for the public to understand and open to accusations of data mining or manipulation.
While this advantage may make core inflation a useful tool for communicating Fed policy
to the public, the empirical evidence suggests it to be, by itself, an inadequate tool for
policym aking.

¹¹ Robert Rich and Charles Steindel, “A Review of Core Inflation and an Evaluation of Its
Measures,” Federal Reserve Bank of New York, staff report no. 236, December 2005. The study
examines the forecasting power of inflation less food and energy, as well as alternative
definitions of core inflation that have been proposed by others.
¹² Todd Clark, “Comparing Measures of Core Inflation,” Federal Reserve Bank of Kansas City,
Economic Review, 2002:2, p. 5.
¹³ Michael Bryan and Stephen Cecchetti, “Measuring Core Inflation,” in N. Gregory Mankiw,
ed., Monetary Policy (Chicago: University of Chicago Press, 1994), p. 195; and Julie Smith,
“Weighted Median Inflation: Is This Core Inflation?,” Journal of Money, Credit, and Banking,
April 2004, vol. 36, no. 2, p. 253. Both studies compared the forecasting ability of many
measures of inflation, and concluded that a weighted median measure of inflation performed best.
¹⁴ William Gavin and Rachel Mandal, “Predicting Inflation: Food for Thought,” Federal Reserve
Bank of St. Louis, Regional Economist, January 2002.
¹⁵ Economists have tried to find the best measure of core inflation according to different criteria.
See Timothy Cogley, “A Simple Adaptive Measure of Core Inflation,” Journal of Money, Credit
and Banking, vol. 34, no. 1, February 2002, pp. 94-113; Danny Quah; Shaun P. Vahey,
“Measuring Core Inflation,” The Economic Journal, vol. 105, no. 432, September 1995, pp.
1130-1144; Michael Bryan and Stephen Cecchetti, “Measuring Core Inflation,” in N. Gregory
Mankiw, ed., Monetary Policy, (Chicago: University of Chicago Press, 1994), p. 195; Todd
Clark, “Comparing Measures of Core Inflation,” Federal Reserve Bank of Kansas City, Economic
Review, 2002:2, p. 5.