How to Measure Changes in the Cost of Living

The CPI and Core Inflation Index

Imagine if you were driving a company truck across the country- you probably would care about things like the prices of available roadside food and motel rooms as well as the truck’s operating condition. However, the manager of the firm might have different priorities. He would care mostly about the truck’s on-time performance and much less so about the food you were eating and the places you were staying. In other words, the company manager would be paying attention to the firm's production, while ignoring transitory elements that impacted you, but did not affect the company’s bottom line.

In a sense, a similar situation occurs with regard to measures of inflation. As we’ve learned, CPI measures prices as they affect everyday household spending. Economists typically calculate a core inflation index by taking the CPI and excluding volatile economic variables. In this way, economists have a better sense of the underlying trends in prices that affect the cost of living.

Examples of excluded variables include energy and food prices, which can jump around from month to month because of the weather. According to an article by Kent Bernhard, during Hurricane Katrina in 2005, a key supply point for the nation’s gasoline was nearly knocked out. Gas prices quickly shot up across the nation, in some places by up to 40 cents a gallon in one day. This was not the cause of an economic policy but rather a short-lived event until the pumps were restored in the region. In this case, the CPI that month would register the change as a cost of living event to households, but the core inflation index would remain unchanged. As a result, the Federal Reserve’s decisions on interest rates would not be influenced. Similarly, droughts can cause world-wide spikes in food prices that, if temporary, do not affect the nation’s economic capability.

As former Chairman of the Federal Reserve Ben Bernanke noted in 1999 about the core inflation index, “It provide(s) a better guide to monetary policy than the other indices, since it measures the more persistent underlying inflation rather than transitory influences on the price level.” Bernanke also noted that it helps communicate that the Federal Reserve does not need to respond to every inflationary shock since some price changes are transitory and not part of a structural change in the economy.

In sum, both the CPI and the core inflation index are important, but serve different audiences. The CPI helps households understand their overall cost of living from month to month, while the core inflation index is a preferred gauge from which to make important government policy changes.

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