Taming Inflation

Inflation is a term that frequently makes headlines in the world of economics and finance, but what exactly is it? In simple terms, inflation is the rate at which the general level of prices for goods and services rises, resulting in a decrease in purchasing power for a given currency. It is a crucial economic indicator that affects everyone, from consumers and businesses to policymakers and investors. It is typically expressed as an annual percentage and is measured by tracking the prices of a basket of commonly purchased goods and services. These items can include food, housing, energy, transportation, and more. To gain a deeper understanding of inflation, it's essential to distinguish between two key types: core inflation and headline inflation.

Headline Inflation

Headline inflation, often referred to as overall or consumer price index (CPI) inflation, represents the broadest measure of price changes in an economy. It includes the prices of all goods and services in the basket, making it comprehensive but also more susceptible to temporary factors. As a result, headline inflation can be influenced by volatile items such as energy and food prices, which tend to fluctuate significantly in response to various external factors. 

The inclusion of these volatile components can lead to relatively erratic changes in headline inflation. For instance, a sudden increase in oil prices or a bad harvest leading to higher food prices can cause headline inflation to spike. While these spikes may be temporary and outside the control of policymakers, they can have a significant impact on public perception and economic decisions.

Core Inflation

Core inflation, on the other hand, is a more stable and focused measure of inflation that excludes the volatile elements of the CPI basket, primarily food and energy. By removing these price fluctuations, core inflation provides a clearer picture of the underlying, persistent inflationary trends in an economy.

The rationale behind excluding food and energy is that these sectors are often influenced by factors such as weather, geopolitical events, and supply chain disruptions, which can cause prices to surge or plummet for reasons unrelated to monetary policy. Core inflation aims to isolate the trends that are more directly influenced by changes in monetary policy, making it a valuable tool for the Federal Reserve and economists.

The old joke about core inflation is that it is only useful for people who don’t need to heat their homes, drive a car, or eat.  However, from a policymaker’s perspective, it is a more reliable tool than headline inflation because it can take out the most volatile factors of inflation to make better decisions.  The chart below shows both versions of inflation for the last 50 years.  The grey line that represents core inflation is much less volatile.

The latest inflation report was released for the month of September.  It reported that overall, or headline, inflation is up 3.7% compared to a year ago, and the core inflation rate (which excludes energy and food) is up 4.1% in the same time period.  That means that the rate of inflation for food and energy was lower than the core factors and including them brought the CPI headline rate down from the core rate.  The inflation rate for energy by itself was negative, meaning that the cost of energy as a group was slightly lower than a year ago.  In this situation, the headline inflation figure reported on the evening news could be considered an incomplete metric that is more favorable than it should be.

So, what does this mean for the Federal Reserve’s battle with inflation?  The Fed has publicly stated that their target for inflation is 2% for core inflation and 3% for headline inflation.  Although a lot of progress has been made in the last year, as the headline inflation rate has come down from a peak of 9.1% in June 2022, the Fed would like to see lower inflation before they declare victory. 

One of the most common and effective ways the Federal Reserve combats inflation is by raising short-term interest rates, particularly the federal funds rate. The federal funds rate is the interest rate at which banks lend reserves to one another overnight. When the Fed raises this rate, it becomes more expensive for banks to borrow money, which, in turn, leads to higher interest rates throughout the economy.

When interest rates rise, it becomes more expensive for consumers and businesses to borrow money. This discourages spending and investment, which can lead to decreased consumer demand and slower economic growth.  The tightrope that the Fed is trying to walk is to reduce economic growth, which will slow down inflation without causing a recession.  After over a year of raising rates, they seem to have accomplished both so far.  But the job is not done, and we will find out over the next few months if they can stay on this tightrope.