Saturday, October 20, 2012

Core Inflation: Why Are Food and Energy Prices Excluded?

While helping out one of my colleagues at university doing homework, I got into graphing stuff. Thanks to that, I'm now a little bit behind my reading for another class, but it's all fine. Hope so. Here are graphs for inflation rate, core inflation rate, food inflation rate, and energy inflation rate.
As you can see, changes in food prices and energy prices are much more volatile than general inflation rate.
Food and energy price volatility is caused mainly by very unstable supply of those markets. Their prices are very easily affected by changes in climate or military tension in the Middle East.
Every year I see news that the price of cabbage skyrockets all of sudden because of sudden coldness or snowfall, and Korean restaurants are considering to stop serving kimchi. The truth is about a month later I see another news that farmers plow up their yards because of a drastic fall in price of cabbage mainly in response to retailers' import of Chinese cabbages to fill the supply shortage. By the way, the bottom line is these volatile prices play a role as outliers. They change so much that an inflation rate that includes those price changes may skew the result and not reflect changes in other prices.
On the other hand, a lot of other prices are set by firms that produce those products. In other words, firms, more or less, have market power. For example, the Apple Inc. just sets its products prices; it does not even let its retailers change prices in response to every day change in demand; when it sets its prices, probably the production costs matter more than any other factors and they are usually pre-determined. In the short run, therefore, their prices are sticky. Therefore, by taking off too volatile food and energy prices, you can see a broader tendency in price changes. 

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