Why are there so many different price indexes and measures of inflation?
Different groups typically care about the price changes of some items more than others. For example, households are particularly interested in the prices of items they consume, such as food, utilities, and gasoline, while commercial companies are more concerned with the prices of inputs used in production, like the costs of raw materials (coal and crude oil), intermediate products (flour and steel), and machinery. Consequently, a large number of price indexes have been developed to monitor developments in different segments of an economy.
The most broad-based price index is the GDP deflator, as it tracks the level of prices related to spending on domestically produced goods and services in an economy in a given quarter. The CPI and the PCE price index focus on baskets of goods and services consumed by households. The producer price index (PPI) focuses on selling prices received by domestic producers of goods and services; it includes many prices of items that firms buy from other firms for use in the production process. There are also price indexes for specific items such as food, housing, and energy.
What is "underlying" inflation?
Some price indexes are designed to provide a general overview of the price developments in a broad segment of the economy or at different stages of the production process. Because of their comprehensive coverage, these aggregate (also called “total,” “overall,” or “headline”) price indexes are of considerable interest to policymakers, households, and firms. However, these measures by themselves do not always give the clearest picture of what the “more sustained upward movement in the overall level of prices,” or underlying inflation, happens to be. This is because aggregate measures can reflect events that are exerting only a temporary effect on prices. For example, if a hurricane devastates the Florida orange crop, orange prices will be higher for some time. But that higher price will produce only a temporary increase in an aggregate price index and measured inflation. Such limited or temporary effects are sometimes referred to as “noise” in the price data because they can obscure the price changes that are expected to persist over medium-run horizons of several years—the underlying inflation rate.
Underlying inflation is another way of referring to the inflation component that would prevail if the transitory effects or noise could be removed from the price data. From the perspective of a monetary policymaker, it is easy to understand the importance of distinguishing between temporary and more persistent (longer-lasting) movements in inflation. If a monetary policymaker viewed a rise in inflation as temporary, then she may decide there is no need to change interest rates, but if she viewed a rise in inflation as persistent, then her recommendation might be to raise interest rates in order to slow the rate of inflation. Consumers and businesses can also benefit from differentiating between temporary and more persistent movements in inflation. For these reasons, a number of alternative measures have been developed to measure underlying inflation.
How is underlying inflation measured?
One popular approach to removing noise in price data has been to exclude components that are viewed as the source of noise in aggregate price indexes such as the CPI or PCE price index. Some of these measures of underlying inflation assume the noise is related to the size of price changes (smallest and largest), while others associate the noise with particular items (with the most common example being food and energy). The median CPI is an example of the former in that all price changes are excluded from the index except the one in the middle, while core CPI and core PCE are examples of the latter, in that both exclude food and energy prices. The Consumer Price Data section talks about underlying inflation measures in more detail.
There are other measures of underlying inflation whose design does not require excluding components. Despite their varied nature, these measures share a common purpose—to provide an estimate of the persistent component of inflation.