The Federal Reserve, for example, pays particular attention to the rate of growth of the core personal consumption expenditure (PCE) deflator, which excludes food and energy prices.  Indeed, in the presentation of its twice yearly Monetary Policy Report to the Congress, the Federal Reserve Board reports the projections of Federal Open Market Committee participants regarding core PCE inflation, not headline inflation, the latter of which includes all items in the price index.  Here in Canada, unlike in the United States, the central bank maintains an explicit inflation target.  The Bank of Canada states its target in terms of the headline consumer price index, and although this choice of inflation measure contrasts with the Federal Reserve's preferred index, the difference is not nearly as great as it appears on the surface.  In fact, the Bank of Canada monitors a number of inflation measures and uses core inflation as an "operational guide" in coming to its monetary policy decisions and discussing these decisions with the public. 

[R]ecent research done at the Federal Reserve Bank of New York on U.S. data finds that no one particular core measure, including the standard one, dominates the others:  The relative performance of different core measures varies depending on the choice of the price index, the sample period, and the criteria for evaluating their performance (Rich and Steindel, 2007).  Research on Canadian and U.K. data comes to similar conclusions (Hogan, Johnson, and Laflèche, 2001; Mankikar and Paisley, 2002).

Does the lack of empirical support for any one particular type of core measure suggest that our focus on the standard core measure should be abandoned?   I think not.  The simplicity and long history of the standard core measure that excludes food and energy gives it several major advantages.  Its simplicity makes it straightforward to explain and thus more understandable to the public--assuming, of course, that we successfully communicate that we recognize the importance of food and energy items in people's consumption. 

Unfortunately, as noted above, empirical research suggests that no one measure of core inflation will work in all situations.  Therefore, central banks do not focus solely on core inflation; rather, they devote considerable resources to understanding inflation developments in an effort to distinguish signal from noise in the incoming data

Those of us responsible for crafting U.S. monetary policy cannot afford to be distracted by the flux of short-term price changes that are destined to be unwound. Our eye should be focused on underlying inflationary pressures, some of which may indeed be coming from food and energy markets. Routinely excluding food and oil price movements from our inflation gauges may have made sense in the 1970s, the 1980s and even the 1990s—but not now, nor in the next few years. The conceptual beauty of trimmed mean inflation measures lies in their ability to capture steady increases in food and energy prices, which may be germane to the pursuit of price stability, while excluding the temporary spikes and dips that do not presage changes in the underlying inflation rate. 

But while core inflation has proven to be a useful tool for gauging underlying inflation trends, it is only a tool. The ultimate responsibility of the Federal Reserve is to achieve low and stable total inflation—not core inflation. Total inflation fully reflects how all price changes erode standards of living. So people's judgment of the Fed's commitment to price stability will be reflected in their long-run expectations of total inflation. In turn, these expectations will be based on the persistent movements in all of the components of consumer prices, including food and energy.

As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first five months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability. ¹  Because monetary policy works with a lag, however, policymakers must focus on the economic outlook.  Food and energy prices tend to be quite volatile, so that, looking forward, core inflation (which excludes food and energy prices) may be a better gauge than overall inflation of underlying inflation trends. 

     The dual mandate says price stability. It doesn't say price stability without energy and food. The Federal Reserve is concerned about the overall inflation rate. That is our long-term objective in the sense of maintaining price stability.

     But there are some technical issues involved in achieving that. In particular, when oil prices rise sharply, as they have in the last few months, there's really not much that the Federal Reserve can do in a short period of time to reverse that.

     Rather, what we have to do is look forward a year to two years, which is the horizon over which monetary policy has its effect. And so we really have to ask ourselves what's the underlying trend of inflation going forward, what's the best forecast of inflation going forward?

     Because energy and food prices have been so volatile, up and down, historically, the core portion, which excludes energy and food, is sometimes a better indicator of where sort of the trend of inflation is going to be a year or two from now.

     So it's not that we think core inflation is more important in itself, but rather we think it's an important indicator of the underlying inflation trend.

     So by paying attention to core inflation, we are in a way saying that this is how we hope to maintain stability in overall inflation over the horizon at which the monetary policy can be effective.

From the Q&A session

I don't think there's any fundamental change in the way the Fed looks at inflation...   My bottom line is that we've always thought about food and energy prices, and I don't see any particular change in thinking.

From audience Q&A, as reported by Bloomberg News

Since 2005, the three- to five-year moving average of U.S. inflation has hovered around 3 percent. This is above where I would like to see the trend settle in the longer run.  [Note:  These figures are measured by the Consumer Price Index.]

[M]onetary policymakers often pay attention to “core” measures of prices that exclude energy and food prices. This focus does not, however, mean that policymakers’ concept of price stability refers only to a basket of goods that excludes energy-intensive items. The overall cost of living is what matters for welfare, so stability over time in indexes that include energy is desirable. But because the price of gasoline is volatile, it is often desirable to “see through” very short-term movements in consumer prices, and work out what is happening to the underlying trend of prices. Looking at core measures of inflation can be useful for this purpose. Indeed core and aggregate inflation clearly move together over longer periods. That said, during periods of sustained increases in relative energy prices, general price stability requires that price indexes that exclude energy will need to grow more slowly than the aggregate price index; over this period, achievement of inflation at a desirable level means that core inflation, on average, proceeds below the overall level of inflation.

As you know, while the costs of food and energy are important to all of us, such costs can spike temporarily due to shortages, such as those that occurred with the devastating hurricanes in the fall of 2005. What concerns policymakers is if these cost spikes feed through to the broader economy -- to prices of non-oil goods and services -- as a result of lengthy supply problems or burgeoning demand or some combination of the two. Thus, the strength in both U.S. and global demand in '05 and '06, combined with rising energy costs, heightened Federal Reserve concerns about inflation.

So we have to be careful not to focus too narrowly on one particular measure. Instead we need to look at many. And indeed here in the United States we look at a range of different measures of core inflation, for example, that take energy and food prices out of the overall index. We look at these over different time horizons. We look at a variety of other measures that use different statistical techniques to strip out the more volatile parts of the index. These all have limitations, and their relative merits may change over time. Central banks approach this challenge of capturing underlying inflation differently, but ultimately we are all judged by what happens to overall inflation over time.

While {the personal consumption expenditures price index} this is an important and comprehensive index of changes in the cost of living, the Committee also focuses on a different measure—the core number, which excludes the volatile food and energy components—because it is a better indicator of underlying trends in inflation.

Appreciating this distinction helps one better understand ideas like "core" inflation, which are useful metrics for the central bank, and perhaps only the central bank, to monitor. These core inflation measures, most commonly constructed as an aggregate price statistic less food and energy prices, attempt to strip away the most volatile of the relative price movements that may temporarily cause the aggregate price measure to fluctuate in a way that is not symptomatic of a persistent change in the purchasing power of money.

The Fed, in the short run, tolerates the pressure rising energy prices exert on headline price measures, Mr. Bernanke said. "Our objective is to make sure it doesn't pass through into other wages and prices, in other words, that there are not second-round effects," he said.

"In the long run, what we would like to control is headline inflation," Mr. Bernanke said, "After all, that's what is determining the value of money, and it's what people need for their planning," along with being the force that "affects real wages and real incomes," he said.

"It is very difficult to eliminate the inflationary impact of the immediate effects of an increase in energy prices," he said. "Doing so would require forcing down wages and other prices quite dramatically to keep the overall price level from rising."

From Q&A session reported by the Wall Street Journal