Monday, July 09, 2007

What's Core

Yesterday we went to the grocery store and, among other things, picked up one red pepper for $2.69 and afterwards filled up the sedan with $48.50 of gas. Food and gas are more or less essential aspects of our lives, although a red pepper could be passed on if we didn't want good omelettes, salads, or onion and pepper burgers.

When measuring inflation the Fed and the bond market focus most of their attention on the core inflation number, or price increase minus food and energy. The historic rationale has been that food and energy are volatile components and therefore a more reliable gauge of inflation is the core number. At times it seems somewhat of a misnomer since what is more core to most peoples lives than food, heat and transportation. That aside, the more important issue is this. What if food and energy are on a longer term upward trend, so that while there is volatility around that trend line, it is going up for the foreseable future.

There are many reasons why that could actually be the case. For starters, today energy is not pressured by some significant supply disruption but gasoline prices have been rising and in addition food costs are being impacted by energy, both in costs of production and transportation and in diversion of acreage to produce crops for ethanol(perhaps a questionable trade-off). The bond market's recent yield increases have been attributed by most to a stronger than expected economy but it would seem logical that there is some segment of the global bond market that actually looks at the total inflation numbers, and is in fact more concerned than the already anxious Fed. The outcome of this will be obvious in the coming months. In the interim, the consumer must allocate spending, according to economists, between core items and those annoying non-core items.

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