Inflation : Definition, WPI, CPI, Measurement and Causes

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. 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.

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. In scenarios like this one, a focus on core inflation could forestall a needed policy change until it is too late.

More recently, the differences have been smaller, with core inflation running at 2.0 percent for the CPI and 1.7 percent for the PCE since 2000, and 1.7 percent and 1.5 percent since 2008. Measures of core inflation attempt to strip out or smooth volatile changes in particular prices to distinguish the inflation signal from the transitory noise. Thus, relative to changes in headline inflation measures, changes in core measures are much less likely to be reversed, provide a clearer picture of the underlying inflation pressures, and so serve as a better guide to where headline inflation itself is heading. Of course, if a particular shock to noncore prices is not temporary but, rather, turns out to be more persistent, then the higher costs are likely to put some upward pressure on core prices. 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.

1. The GDP figure is a measure of the production of all goods and services in the U.S.
2. 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.
3. However, core PCE and CPI are similar, and both help to determine how much inflation is in the economy.
4. The speculation of energy and food commodities leads to volatility in their prices, causing wild swings in the inflation figures.
5. There can be two sets of factors that can cause inflation in an economy.

There are different indices in India like Wholesale Price Index(WPI), Consumer Price Index(CPI), etc. which measure inflation rates in India. But what we generally find in headlines is the rate in India is a rate based on WPI. In the last 50 years, the WPI-based rate shows an average inflation rate of around 7-8%.

While headline inflation is the total inflation for the economy, core inflation is believed to represent the underlying trend in inflation and hence often used by policy makers to determine the future strategies for the economy. Researchers have studied the properties of these inflation measures, and argued that they have better predictive properties for headline inflation than core inflation. This seems reasonable, but the core inflation measure is actually more useful for analysts making short-term inflation forecasts in practice. In particular, for those who are making forecasts of inflation-linked bond carry.

Revision of Wholesale Price Index (WPI)

If we look at the bottom panel (headline inflation) near the Financial Crisis, we see that wage growth was completely decoupled from the wild swings in headline CPI inflation (due to the oil price spike then collapse). Meanwhile, core inflation was more stable, resembling the trend in wages. Even more concerning may be the rise in “core inflation”, which excludes food and energy prices in order to create a less volatile picture of domestic price rises. It is closely monitored by the Bank of England, and rose to 7.1 per cent, after April’s figure was already a 30-year high. A central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations.

How is inflation calculated?

In this case headline inflation will rise well above its underlying trend as the price of energy rises but will soon fall well below its underlying trend as the price of energy falls back to its initial level. On average, inflation will remain unchanged without any monetary policy action. The outcome of such a policy would be a more pronounced fall in inflation with a decline in employment.

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.

Inflation can be measured at three levels – producer, wholesaler, and retailer (consumer). Prices generally rise at each level till the commodity finally reaches the hand of the consumer. Finally, core and headline inflation difference the indexes differ in how they account for changes in the basket. This is referred to as the formula effect, because the indexes themselves are calculated using different formulae.

Both the government and central bank (Reserve Bank) try to tackle inflation with their policies which are known as Fiscal and Monetary Policies respectively. This example clearly explains the fall in the purchasing power of money. The calculations for a trimmed mean and median CPI are fairly straightforward, but the difficulty with them is that they are based on weighted averages. (All of the groupings in the CPI basket have different weights, based on consumption patterns.) Dealing with the weightings makes the calculations look more complicated than they really are. Inflation rates can increase due to several factors, including higher production costs and a surge in demand for products and services.

Inflation causes the value of money or income to decrease in comparison to the prices of basic goods and services. The chart above indicates that the two measures have not greatly diverged in the long run. I chopped down the period shown to be the low inflation period of 1994 to present.

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. In the end, the question of what measure of inflation is best for policymaking is an empirical one. 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. 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 policymaking. Although monetary policy is capable of controlling overall inflation in the long run, it does not have the ability to control relative price movements such as those for food and energy. When a cold snap freezes the Florida orange crop or a tropical storm hits the gasoline refineries along the Gulf Coast, monetary policy cannot reverse the resulting spikes in prices for fresh orange juice or for gasoline at the pump.

#2: CPI components of Consumer Price Index

For example, TIPS are an inflation-protected bond issued in the United States. The fixed income instruments yield headline inflation plus a small spread. The first step in calculating the lower level index is creating a basket of goods and services consumed by the average consumer.

Inflation: Core vs. Headline

Of course, to the extent that such a bias in a core inflation measure is stable or predictable, the central bank could easily take this into account in setting monetary policy. But even in that case, differences in average rates of inflation between the core measure and overall inflation could complicate communication with the public. Here in Canada, unlike in the United States, the central bank maintains an explicit inflation target.

What is the difference between headline inflation and core inflation?

But, in light of the shock inflation figures, some economists have now suggested the Bank could decide to implement a more dramatic increase of 0.5 per cent. The chart below breaks down the differences between the CPI and PCE into these four effects for each quarter starting in 2007. The largest difference tends to be the weight effect, which contributes to bigger changes in the CPI, while the scope effect tends to lessen the difference. There are a few more, mostly minor differences, related to items such as how seasonal adjustments are handled. Another aspect of the baskets that leads to differences is referred to as coverage or scope.

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 https://1investing.in/ 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.