Core Inflation is also known as underlying inflation, is a measure of inflation which excludes items that face volatile price movement, notably food and energy. In other words, Core Inflation is nothing but Headline Inflation minus inflation that is contributed by food and energy commodities. To understand the concept in a better way we can say that food and fuel prices may go up in the short run due to some disturbance in the agriculture sector or oil economy. However, over the long term they tend to revert back to their normal trend growth. On the other hand, prices of other commodities do not fluctuate as regularly as food and fuel – as such increase in their prices could be taken relatively to be much more of a permanent nature. If this is so, then it follows logically for Central Banks to target only core inflation, as it reflects the demand side pressure in the economy. In practice too, the Reserve Bank of India (RBI) and Central Banks around the World always keep an eye on the core inflation. Whenever core inflation rises, Central Banks increase their key policy rates to suck excess liquidity from the market and vice versa. It is, therefore, a preferred tool for framing long-term policy.
Here it needs to be mentioned that, unlike core inflation, headline inflation also takes into account changes in the price of food and energy. Since food and energy prices are highly volatile, headline inflation may not give an accurate picture of how an economy is behaving. Responding to headline inflation might therefore sometimes be inappropriate as it generates excessive variability in the unemployment rate – variability that would be much more subdued when policy responds to core inflation.
This is because, it is important to distinguish between temporary (like seasonal variation in fruits and vegetable prices) and permanent changes in prices. While temporary changes would reverse and might not warrant attention, permanent changes would require standard remedies involving monetary and fiscal policies. Research has shown that headline inflation tends to revert strongly towards core inflation once the temporary fluctuation in food and energy sector stabilizes.