Headline inflation is the total inflation in an economy. The headline inflation figure includes inflation in a basket of goods that includes commodities like food and energy. It is different from core inflation, which excludes food and energy prices while calculating inflation.
Food and energy are not included in core inflation because their prices are volatile. It makes headline inflation a more volatile measure than core inflation. The point is illustrated by the chart below, which plots core and headline inflation data from the Bureau of Labor Statistics (base year 1984).
Headline Inflation and Monetary Policy
Many central banks around the world are mandated to maintain the price level in the economy. The mandate explicitly states the measure of the price level to be used while designing monetary policy.
Most central banks use headline inflation or a similar measure as their target variable. The reason being headline inflation is a broad measure that closely represents the basket of goods and services consumed by most households. Some major central banks that use headline inflation are the Bank of England, the European Central Bank (ECB), and the Reserve Bank of India.
The Federal Reserve also uses a similar measure called the Personal Consumption Expenditure Index (PCE Index), which tracks the Consumer Price Index (CPI). The CPI is the main headline inflation indicator in the United States. The figure is calculated and published by the Bureau of Labor Statistics (BLS).
Headline inflation, being more volatile, cannot be used to calculate inflation trends and is often substituted with core inflation to see the direction of the trend. Some economists argue that core inflation or similar measures should be used to design monetary policy. The main argument being that volatility in food and energy prices are short-term fluctuations.
Calculating Headline Inflation
The Consumer Price Index (CPI) is a common measure of headline inflation. Here, we discuss how the CPI is calculated in Canada. Statistics Canada is the organization responsible for calculating and publishing the CPI number. A similar process is used elsewhere in the world to calculate headline inflation.
The CPI is calculated in two levels, viz. the elementary index or the lower level, and an upper level. Further adjustments are made for the change in the quality of the products and seasonal adjustments.
The first step in calculating the lower level index is creating a basket of goods and services consumed by the average consumer. The sample includes 645 unique products. Then, an elementary index is calculated as an equally weighted average.
Equal weighting is used because the quantities consumed are not available without extensive sampling. The initial index is calculated using the Jevons Formula. The formula is illustrated below:
It is the geometric mean of ratio prices of the goods and services in the sample of goods. The decision to use the geometric mean instead of the arithmetic mean was made in 1996. The reason behind the shift was that the arithmetic mean is more sensitive to extreme observations. Since headline inflation is already a volatile measure, the use of geometric mean makes it a better measure.
Once the lower-level index is calculated, the inflation index needs to be adjusted for quantities. It is to ensure a more accurate reflection of the consumer basket. The formula used for calculating the upper-level index is called the Laspeyres Price Index and is calculated as follows:
A modified version called the Lowe Index is also used if the data for quantities consumed is not available for the reference period.
Headline inflation is also used for other policy measures and financial instruments. For example, TIPS are an inflation-protected bond issued in the United States. The fixed income instruments yield headline inflation plus a small spread.
Many government payments are also benchmarked against headline inflation. The amount of certain payments like social security are adjusted for inflation. The adjustments are based off the headline inflation figure.
It is common for products to improve in quality while the price remains the same. It is especially applicable to technology products like cell phones and computers. The products vastly improve in quality, while the prices remain flat.
Hence, the price of the products needs to be adjusted for changes in quality. It is also common to adjust rent for quality, including changes in the quality of the neighborhood where the property is located. The adjustment is made through a simple regression.
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