Debate Politics Forums - View Single Post - Headline and Core Inflation: A Recent Decoupling

donsutherland1 · 07-17-08, 01:23 PM

In June, 12-month headline inflation soared to 5.0%. Meanwhile, core inflation ticked up ever so gently to 2.4%. The difference amounts to 206.87 basis points, the highest since September 2005 when the spread was 271.10 basis points. The September 2005 spread will likely be surpassed when the July and August Consumer Price Index (CPI) data is released. It is possible that the spread could reach or exceed 300 basis points, especially as the August year-over-year headline inflation rate could be approaching 6%.

This development raises the question as to whether the core inflation figure is as relevant as it once was. In the past, it was argued that food and energy prices are highly volatile and excluding those prices from the overall CPI figure would eliminate the noise caused by such volatility. That argument worked well so long as fluctuations in food and energy prices assured that the core inflation figure would come out close to the headline figure over the long-run.

However, by the early 2000s, headline inflation began to decouple from core inflation. In general, the annual headline inflation figure began to exceed the core figure on a regular basis. During the January 1995 through October 2002 timeframe, in 51/94 (54.3%) of months, the annual headline figure came out less than the annual core figure. As a result, a more aggressive anti-inflation policy could target core inflation. However, from November 2002 through June 2008, the annual headline figure exceeded the core figure in 61/68 (89.7%) of months.

Since April 2004, the divergence between the two inflation figures has accelerated. Early evidence suggests that a pronounced rise in energy prices is likely driving that decoupling.

The divergence between headline and core inflation shows up quite well when headline inflation is indexed for core inflation. In early 2004, one witnesses the beginning of a sustained divergence between the headline and core CPI.

Given the leading role energy price trends appear to have played, it makes sense to examine the price of crude oil. The data reveals that at the time headline inflation was accelerating in its divergence from core inflation, the ascent in the price of crude oil was accelerating.

Right now, it remains too soon to suggest that the price of crude oil will slow its increase for an extended period of time, or even retreat substantially over coming years. The International Energy Agency’s medium-term oil report suggests that a general continuation of a narrow balance between supply and demand. If so, the price of crude oil might well prove far stickier on the upside than it did during the 1980s and 1990s. If that becomes the case, the utility of focusing on the core inflation figure will diminish. Furthermore, a general focus by central banks on the core figure could allow for a persistent widening of the spread between the headline and core rates. In turn, because consumers lack the ability to exclude food and energy from their purchases, tolerance of higher headline inflation from a focus on the core rate could lead to increasing inflation expectations and a growing risk of second order effects.

07-17-08, 01:23 PM	#1 (permalink)
donsutherland1 Moderator Mod team member Join Date: Oct 2007 Last Online: Yesterday 11:36 PM Location: New York Posts: 2,465 Thanks: 812 Thanked 1,571 Times in 877 Posts Lean: Centrist Gender: Awards:	Headline and Core Inflation: A Recent Decoupling In June, 12-month headline inflation soared to 5.0%. Meanwhile, core inflation ticked up ever so gently to 2.4%. The difference amounts to 206.87 basis points, the highest since September 2005 when the spread was 271.10 basis points. The September 2005 spread will likely be surpassed when the July and August Consumer Price Index (CPI) data is released. It is possible that the spread could reach or exceed 300 basis points, especially as the August year-over-year headline inflation rate could be approaching 6%. This development raises the question as to whether the core inflation figure is as relevant as it once was. In the past, it was argued that food and energy prices are highly volatile and excluding those prices from the overall CPI figure would eliminate the noise caused by such volatility. That argument worked well so long as fluctuations in food and energy prices assured that the core inflation figure would come out close to the headline figure over the long-run. However, by the early 2000s, headline inflation began to decouple from core inflation. In general, the annual headline inflation figure began to exceed the core figure on a regular basis. During the January 1995 through October 2002 timeframe, in 51/94 (54.3%) of months, the annual headline figure came out less than the annual core figure. As a result, a more aggressive anti-inflation policy could target core inflation. However, from November 2002 through June 2008, the annual headline figure exceeded the core figure in 61/68 (89.7%) of months. Since April 2004, the divergence between the two inflation figures has accelerated. Early evidence suggests that a pronounced rise in energy prices is likely driving that decoupling. The divergence between headline and core inflation shows up quite well when headline inflation is indexed for core inflation. In early 2004, one witnesses the beginning of a sustained divergence between the headline and core CPI. Given the leading role energy price trends appear to have played, it makes sense to examine the price of crude oil. The data reveals that at the time headline inflation was accelerating in its divergence from core inflation, the ascent in the price of crude oil was accelerating. Right now, it remains too soon to suggest that the price of crude oil will slow its increase for an extended period of time, or even retreat substantially over coming years. The International Energy Agency’s medium-term oil report suggests that a general continuation of a narrow balance between supply and demand. If so, the price of crude oil might well prove far stickier on the upside than it did during the 1980s and 1990s. If that becomes the case, the utility of focusing on the core inflation figure will diminish. Furthermore, a general focus by central banks on the core figure could allow for a persistent widening of the spread between the headline and core rates. In turn, because consumers lack the ability to exclude food and energy from their purchases, tolerance of higher headline inflation from a focus on the core rate could lead to increasing inflation expectations and a growing risk of second order effects.

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