Core inflation includes which of the following ? 1. Food prices 2. Energy prices Select the answer using the codes given below :

Correct — D, (d) Neither 1 nor 2.

Core inflation is defined by what it leaves out, and the two things it leaves out are exactly the two things this item asks about.

The Economic Survey states the definition in one sentence: core inflation is measured by excluding food and energy items from headline consumer price inflation. So food prices are not included in core inflation, and neither are energy prices. Both entries in the list are outside it, and the answer is the option that admits neither.

The reason for the exclusion is worth understanding, because it is what makes the measure useful. Food and fuel prices are the most volatile components of the index. They move on the monsoon, on a cold snap, on a shipping disruption, on a decision taken by an oil-producing cartel - shocks that are large, are often reversed within a few months, and lie outside the reach of domestic monetary policy. A central bank that responded to every such movement would be tightening in one quarter and loosening in the next for reasons that had nothing to do with the underlying pressure of demand on supply.

Stripping those items out leaves a measure that moves more slowly and reflects the persistent, demand-driven component of inflation - the part that monetary policy can act on. Core inflation is therefore used as a guide to the direction of policy, while headline inflation, which includes everything, remains the number against which a formal inflation target is set and assessed.

One clarification that these papers have tested before: excluding food and energy does not mean excluding everything volatile. Housing, for instance, is classified as a core service and stays inside the measure, even though rents can move sharply. The exclusion is defined by category, not by a test of volatility applied item by item.

Why the others are wrong

• (a)1 only — This option includes food prices in core inflation, which reverses the definition. Food is the largest single group in India's consumer price index and by some distance the most volatile, driven by the monsoon, by sowing and harvest cycles and by the prices of a handful of vegetables; it is the first thing excluded when a core measure is constructed. A candidate may be drawn to this option by the thought that food is too important to leave out of any serious measure of inflation - which is true of headline inflation, and is precisely why the two measures are reported side by side.
• (b)2 only — This option includes energy prices in core inflation, and it is wrong for the same reason. Fuel and light form their own group in the consumer price index, and their movements are dominated by international crude prices and by administered price changes - influences that are external to domestic demand and often sharply reversed. Excluding them is half of what the word 'core' means. A candidate choosing this option has usually remembered that core inflation excludes something volatile and has recalled only the food half of the exclusion.
• (c)Both 1 and 2 — This option includes both, which makes core inflation identical to headline inflation and leaves the term with no content at all. If food and energy were inside the measure there would be nothing to distinguish the two series, and no reason for statistical agencies and central banks to publish both. The option is a useful reminder that a definition constructed by exclusion can be tested by asking what would remain if the exclusion were dropped - here, nothing that is not already the headline number.

Inflation in India is measured principally by the Consumer Price Index (Combined), compiled by the National Statistical Office, and it is reported in two forms.

Headline inflation is the rate of change of the whole index, covering every group in the consumption basket - food and beverages; pan, tobacco and intoxicants; clothing and footwear; housing; fuel and light; and miscellaneous items including health, education, transport and personal care.

Core inflation is the same index with food and energy items excluded. It is sometimes described as non-food non-fuel inflation, which states the construction directly.

The distinction serves a purpose. Monetary policy works with a lag of several quarters and cannot influence the price of onions this month or of crude oil at all. What it can influence is the persistent, demand-driven component of inflation, and core inflation is the best available proxy for that component. A rise in core inflation suggests that price pressure has become general and is likely to persist; a rise confined to headline inflation, with core unchanged, suggests a supply shock that will pass.

Two further points these papers have tested. First, India's formal inflation target - four per cent with a tolerance band of two percentage points on either side, under the monetary policy framework - is set on headline consumer price inflation, not on core, precisely because it is the headline number that households experience. Second, the exclusion is by category and not by a volatility test on each item: housing, for example, is treated as a core service and remains within the measure.

Key facts

• Core inflation is measured by excluding food and energy items from headline consumer price inflation, and is sometimes described as non-food non-fuel inflation.
• Food and fuel are excluded because their prices are volatile and driven by supply shocks - the monsoon, harvest cycles, international crude prices - that monetary policy cannot influence.
• Headline inflation covers the whole consumption basket and is the measure against which India's formal inflation target of four per cent, with a tolerance band of two percentage points either side, is assessed.
• Core inflation is used as a guide to the persistent, demand-driven component of price pressure, and is therefore watched closely as an indicator for policy direction.
• The exclusion is by category rather than by an item-by-item test of volatility: housing, for instance, is classified as a core service and remains within the core measure.

Common traps

• Including food in core inflation because it is the largest group in the index; its size is a reason to report it in the headline measure, not to keep it in the core.
• Remembering only half the exclusion and leaving energy inside the core measure.
• Assuming core and headline are alternative names for the same series, which would leave the distinction with no content.
• Believing that everything volatile is excluded from core inflation; the exclusion is defined by category, and housing stays in.
• Confusing the measure used for the inflation target - headline - with the measure watched for policy direction.

• practice — not a real PYQ

  India's inflation target under the monetary policy framework is specified in terms of :

  • (a)Core consumer price inflation
  • (b)Headline consumer price inflation
  • (c)Wholesale price inflation
  • (d)The GDP deflator

  Answer(b) Headline consumer price inflation - the target of four per cent with a band of two percentage points either side is set on the all-groups Consumer Price Index (Combined), because that is the measure households experience. Core inflation is watched as a guide to policy direction rather than as the target.

• practice — not a real PYQ

  Consider the following statements about core inflation : 1. It excludes food and energy items from the headline index. 2. It is generally less volatile than headline inflation. Which of the statements given above is/are correct ?

  • (a)1 only
  • (b)2 only
  • (c)Both 1 and 2
  • (d)Neither 1 nor 2

  Answer(c) Both 1 and 2 - the exclusion of food and energy is what defines the measure, and removing the most volatile groups is precisely what makes the resulting series smoother than the headline number.