Mohit GolchhaÂ asked me what “core inflation” was a few weeks ago, andÂ I thought this was an interesting topic that merits a post.
However, core inflation can only be understood in the overall context of inflation, and that’s why I have broadened the scope of this post.
When you see inflation numbers reported in the press – you usually hear about WPI (Wholesale Price Index) and CPI (Consumer Price Index) and then you also hear about core inflation and headline inflation.
In India, WPI is the number that’s widely followed and used to report inflation, and the headline inflation number refers to the WPI inflation number that’s reported every month. For example, you may see the following text in the newspapers:Â
Indiaâ€™s headline inflation declined sharply to 6.62 percent in January from 7.18 percent in December â€“ its slowest pace in three years â€“ less than 7.0 percent predicted by the economists polled by Reuters.
The Wholesale Price IndexÂ (WPI) declined as the prices of fuel and manufactured items cooled moderately in December, compared to those in the previous month.
Usually, most references are to this number, although there is a contention that CPI is a better index for measuring inflation in India. Â We won’t however get into that for the purpose of this post.
The Need for Core Inflation
Headline Inflation or WPI or CPI measures the cost of living in a country and tells us how expensive or cheap living in a country has become over the years and for this reason it has components weighted in more or less the same proportion you would expect to consume them.
The RBI creates monetary policy with a goal to achieve a certain target inflation rate, and the way monetary policy affects inflation is by influencing the aggregate demand in the economy.
Simply put, if RBI thinks the economy is over heated and there is high inflation then they will raise interest rates which will make it harder for people to buy things like cars and homes on a loan and that will lower the overall demand in the economy, and in turn it cool down inflation.
However, demand is not the only factor that causes inflation, there are supply side factors as well, specially factors like food and energy prices that are caused by international factors or temporary supply shocks that cause demand. RBI can’t use the headline inflation number alone to make their decisions because these include supply side factors also which are considered temporary and volatile in nature. Two examples of such supply side shocks are the drought in 2009 and the oil price hike of 2010.
To remove the effects of such factors, RBI and other central banks use another measure of inflation which is called “Core Inflation”. Core inflation only tracks those items that can be influenced by monetary policy, and removes the effect of other items.
In India, the measure for core inflation is WPI excluding primary articles, fuel groups and food items, and this index is called NFMI (Non Food Manufacturing Index). The NFMI consists of components that are 55% of the weight of the WPI and this link does a great job of explaining how to calculate the Non Food Manufacturing Index or India’ Core Inflation measure.
So, in conclusion, the idea behind core inflation is that you get an index that can serve you better in gauging the effect of monetary policy on inflation rates by removing the components that are volatile in nature and Â are more prone to price rises due to supply side shocks.