Inflation is defined as the general rise in price level in an economy in a given period of time. Core inflation is a subset of overall inflation, which normally excludes volatile items such as food and energy from the overall inflation and is perceived to be reflecting the demand-side inflation. Core inflation is used by central banks for policymaking purposes. If core inflation is higher than the comfort level of the central bank, it will raise interest rates to curb demand, and cut rates if the inflation is below the comfort level to simulate demand. The last rate cut by the Reserve Bank of India in April was based on softer core inflation as the headline inflation is still above its comfort level of 5%.
Why is it important?
As food and energy prices can be volatile and policy judgments based on volatile prices can lead to greater uncertainty, which affect expectations and economic activity in the economy. Also, monetary policy may not be the appropriate tool to deal with such supply side shocks. For example, if the food prices go up due to some supply-side disruption resulting in a demand-supply mismatch, an interest rate hike may not solve the issue, as interest rate may not affect the food consumption in the economy at that particular point of time. On the contrary, a rate hike may affect the productive side of the economy due to higher cost of capital and affect growth. Also, there is a chance that the supply-side issues get resolved on its own and prices come down quickly. The central bank will have to lower rates, leading to greater amount of policy uncertainty.
What it means to central banks
Should central banks focus only on core inflation? Though core inflation has become more fashionable in the central banking circle these days, there is no general agreement among economist that central banks should always ignore food and energy inflation. In fact, there is a chance that higher sustained inflation in the food, for example, can become generalized and start pushing the core inflation as well. Sustained higher food inflation would force labour market to ask for revision in wage contracts. Higher wages would lead to higher cost of production and higher prices. Therefore, it becomes important for the central bank to look at inflation numbers much more carefully in order to gauge the cause on effect of items, especially in a developing economy due to high weightage of food in the consumption basket for large number of people.