Why does high core inflation lead to persistent broad inflation?

2023 © Wikiask
Main topic: Humanities
Other topics: U.S., Inflation
Short answer: Yes. Core inflation may result in broad/headline inflation through direct or indirect effects like wage-price stickiness.

Inflation measures the increase (or decrease) of prices, typically of a basket of goods, like the U.S. Consumer Price Index (CPI).[1]

Core inflation measures inflation on a sub-basket of assets, typically excluding food and energy prices, two volatile components of the consumer basket.

Illustration of U.S. dollar bills on fire.
Illustration of U.S. dollar currency notes on fire denotes the currency's reduced purchasing power.

Food and energy prices are volatile and mean-revert[edit]

Since food and energy are the asset classes that are traded on the commodities market, their prices are erratic. Most food (such as soya, beef, etc.) and energy (liquified natural gas, petroleum) are purchased and sold in commodity markets.

Consider, for instance; commodity traders bid higher on soya if they anticipate a decline in supply or an increase in demand. They may believe that a weather change will deplete the soya supplies. They will purchase soya at today's price to sell it at tomorrow's predicted higher price. It results in price fluctuations. If the weather change does not have much effect, the selling price of soya will fall when they are selling.[2]

Mean reversion is a financial term describing the hypothesis that an asset's value will tend to move back over time to its long-term average price. The food and energy price fluctuations may not be tied to a trend that shifts the economy's general price level. Instead, fluctuations in food and energy costs are often attributable to short-term reasons that may revert to the mean value in the future.[3]

Non-core inflation can spill over to core inflation[edit]

In a world where core inflation is low, price setters may expect that any high non-core inflation will dissipate over time, so they will not readjust non-core prices based on core prices. For example, if a war leads to an energy inflation of 50%, a service provider, like a barber shop, is not expected to adjust their prices by the same 50%.

The more prolonged non-core inflation is, the higher the probability of core inflation catching up.[4]

Salaries and price stickiness results in inflation spiral[edit]

Due to high inflation, the employees' salaries will also be increased. Salaries account for a sizable portion of business expenses. Hence, salary increase is a significant factor in inflation. Inflation may increase if pay growth surpasses productivity growth and companies raise prices to protect profits and profitability.

Alternatively, if inflation is peaking due to different factors, then the increase in inflation will directly correlate to increasing wages. It is partly because workers frequently seek more significant salary hikes when inflation peaks for an extended duration. Their expectation of higher salaries comes from rising expenses, and their purchasing capacity is reduced due to rising costs. Company expense rises in return, which feeds the cycle.[5]

References[edit]

  1. "CPI Home : U.S. Bureau of Labor Statistics". www.bls.gov. Retrieved 2022-10-13.
  2. "What is "core inflation," and why do economists use it instead of overall or general inflation to track changes in the overall price level? – Education". San Francisco Fed. Retrieved 2022-10-14.
  3. Akdoğan, Kurmaş (2018-12-01). "Mean-reversion and structural change in European food prices". Central Bank Review. 18 (4): 163–173. doi:10.1016/j.cbrev.2018.11.002. ISSN 1303-0701.
  4. Team, Wallstreetmojo Editorial (2022-07-29). "Core Inflation". WallStreetMojo. Retrieved 2022-10-14.
  5. "Wage-price spiral". Economics Help. Retrieved 2022-10-14.