Just last year, as commodity prices were soaring to record levels, there was intense debate going on amongst financial pundits as to whether the importance the fed attached to core inflation was warranted. The measure of core inflation came about in the 1970's, during a period where there was a tremendous amount of volatility in commodity prices. The volatility was such that it rendered the broader headline inflation measure (which includes both food and energy) almost useless.
More recently, in the age of globalization, volatility in commodities seemed to have subsided markedly, and a steady upward trend in food and oil prices were observed over a relatively long period. This change in price behavior is what prompted the debate on the usefulness of core inflation, given that with steady prices, headline inflation measures were considered to be superior as a leading indicator of inflation trends. Just as pundits were getting comfortable with the idea of ditching core inflation, a financial crisis erupted, sparking a huge revival in volatility and sending commodity prices on a tailspin. At its most recent results, headline inflation has plummeted dramatically and is now well below the core measure. The core measure has remained relatively steady which is somewhat reassuring but not entirely so given that the current crisis still has some distance to run its course. Although central banks have injected a tremendous amount of liquidity into the markets doubts still linger as to whether it is enough to eliminate the risk of a deflationary spiral taking hold. If the household mindset begins to shift towards expectations of future price drops, we may very well see a gradual decline in the core inflation measure. Once that sets in, the past suggests that it will be very difficult to reverse.
