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Explainer: What inflation terminology means

With so much talk about disinflation in the euro area, and perhaps even deflation, it's a good time to review some of the terminology economists use when discussing how prices change over time.

Headline inflation: This is the inflation rate you hear announced in the news. It's intended to capture the average change in the basket of goods and services consumed by a typical household. It reflects a general rise in all prices, usually driven by changes in the quantity of money in circulation.

Core inflation: This is inflation, but with food and energy prices removed. The Federal Reserve focuses on core inflation as part of its policymaking process.

Why does the Fed strip out these important prices? If the question is "what is today's inflation rate," the total, or headline inflation, rate is the best measure -- no reason at all to strip anything out. But if we want to forecast future inflation, core inflation is used.

The reason is that food and energy prices are highly volatile, and they can easily give misleading indications of where inflation is headed. When food and energy prices are removed to obtain a core measure, it gives a better picture of the core, or long-run, inflation rate households face. (The Fed also strips out highly volatile components of the inflation index with a procedure known as "alpha trimming." For example, the Dallas Fed removes the 24 percent of prices that fell the most, and the 31 percent that rose the most, to get its so-called Trimmed Mean PCE Inflation Rate. As the Dallas Fed explains in its description of this measure, it's much like tossing out the highest and lowest scores in a figure-skating competition to get at the "core" scores).

There's another reason to focus on core inflation. In theoretical models used to study monetary policy, the best measure of prices for policymakers to target is usually something that looks like a core measure of inflation. Essentially when prices are "sticky" (or not changing rapidly), which is the most common assumption driving the interaction between policy and movements in real variables in these models, it's best to target an index that gives most of the weight to the stickiest prices. That means volatile prices such as food and energy should essentially be tossed out of the index.

Disinflation: This means the rate of inflation is falling, but is still above zero. For example, if the inflation rate declines from 7 percent to 5 percent, that would be disinflation.

Deflation: This is when the inflation rate is negative, i.e. prices are falling on average rather than rising at all. If prices in the basket of goods and services used measure changes in the cost of living are falling at -2% on average, that would be deflation

Hyperinflation: This is when a country experiences extraordinarily high rates of inflation, e.g. more than 50% per month. This often leads to a loss a faith in the currency and a highly costly breakdown in the country's ability to carry out its day-to-day economic transactions.

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