Core Inflation: Measures and Their Choice

1
Core Inflation Measures and Their Choice

• Mick Silver
• IMF Statistics Department
• Joint UNECE/ILO Meeting on Consumer Price Indices
  (Geneva, 10-12 May 2006)

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Introduction

• Countries that adopt inflation targeting require
  a credible, timely measure of inflation to
  target usually CPI.
• Some components of the CPI, including food and
  energy, are particularly volatile and usually
  excluded. So too may be indirect taxes and
  interest (mortgage) payments.
• The resulting core inflation measure is used
  for inflation targeting, though it is not always
  clear which components should be excluded.

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Credibility target and operational methods

• Many possible methods and different measures
  serve different purposes
• Target measure timely and credible, may be CPI.
• Operational measures
• best smooth
• best predict
• Several core inflation measures may be used by
  the monetary authorities as operational guides
  for analytical and forecasting purposes with
  respect to achieving the target.

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Responsibility central bank vs. statistical
authority

• Depends on country circumstances
• Credibility responsibility should ideally lie
  with an autonomous statistical authority.
• Integration into inflation targeting regime a
  central bank must have a major role to play in
  the development of these measures.
• Central bank may be responsible for measure based
  on use of statistical authority's CPI data.
• In some countries central bank is responsible for
  CPI.

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A derived statistic error and bias

• Product substitution
• Outlet substitution
• Index formula bias
• Out-of-date weights Young and Lowe
• Quality change
• New goods
• Inappropriate coverage
• Unrepresentative sampling
• Bias/errors in data on prices/weights

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The paper

• first, to outline the range of methods available
  and advocate the use of more than one measure.
• second, need to choose between the alternative
  methods and to promote a data-driven approach.

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No single best method

• There are many approaches, ways of implementing
  them, and methods for judging which is best.
• Empirical research shows that different measures
  of core inflation yield different results, that
  is, that choice of measure matters.
• Further, that different approaches to the choice
  as to which is best yield different results
• Even for the same approach to choice, the
  preferred measure may differ across countries,
  and even within a county for different time
  periods.

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The methods

• Exclusion-based methods
• Product groups
• Indirect taxes
• One-off shocks
• Domestically generated inflation
• Imputation methods
• Trend estimates
• Limited influence estimators
• Median
• Trimmed meanssymmetric and asymmetric
• Reweighting the CPI
• Persistence weights
• Volatility weights
• First principal component
• Economic models

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Exclusion-based methods volatile prices

• Exclusion-based methods exclude component price
  indices of a CPI that are considered to be
  particularly volatile.
• Easy to understand, timely, and transparent, in
  that the user can replicate the measure.
• Exclusion-based methods are often used by
  countries when they first instigate inflation
  targets.
• A common approach is simply to exclude certain
  product groups. Usual exclusions are food and
  energy (FE) argued on the basis of their undue
  volatility
• Standard exclusions used by a number of
  countries has the advantage that the authorities
  are less likely to be perceived to be
  manipulating the targeting.

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Exclusion-based methods but....

• What is volatile in one country is not in
  another.
• The level of disaggregation matters some
  seasonal foods only.
• Data-driven which products are volatile and the
  longevity of the volatility.
• Objective method of determining which to products
  to exclude
• z x SD trimmed mean
• but exclusions should not damage credibility.

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Exclusion-based methods other exclusions

• Indirect taxes
• Interest rates
• Other major one-off or erratic shocks
• Domestically generated inflation

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Exclusion-based methods imputations

• Weights of excluded items might be better
  apportioned to product groups likely to
  experience similar uncontaminated price changes

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How to choose between measures general
considerations

• timely
• credible (verifiable)
• easily understood by the public
• and not significantly biased (robust) with
  respect to the targeted measure
• have a track record of some sort
• have some theoretical basis
• not be subject to revisions.

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Judging which method to use

• Justifying the Exclusion of Product Groups on the
  Basis of their Volatility
• Justifying the Exclusion of Product Groups on the
  Basis of their Volatility
• Judging on the Basis of Deviations from a
  Reference Series
• Judging on the Basis of Predictive Ability
• Judging on the Basis of Predictive Ability
• Judging on the Basis of Correlation with Money
  Supply

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Concluding remarks

• The empirical research shows that different
  measures yield different results, that is, that
  choice of measure matters.
• Further, that different approaches to the choice
  of measure yield different results
• and, even for the same approach to choice, the
  preferred measure may differ across countries,
  and even within a county for different time
  periods.
• Choice of measure should thus, in principle, be
  data-driven for each country based on appropriate
  criteria

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Concluding remarks

• However, a consensus has emerged and, for reasons
  of maintaining credibility, this is for many
  countries a natural starting point.
• First, is the use of the CPI as the basis for the
  core inflation measure, as the most visible and
  credible measure to anchor inflation
  expectations.
• Second, is the widespread adoption of
  exclusion-based CPIs. There is some commonality
  in the products groups excluded and such
  exclusions can thus be justified as not
  manipulating the figures.

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But......

• The decision as to what to exclude should be
  country-specific.
• Where the CPI or an exclusion-based CPI is
  adopted it may be necessary for the central bank
  to have further measures to operationalize the
  targeting framework.
• Exclusion-based methods may be found to not be
  best.

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Data- and research-driven

• All of this should be data driven, so that the
  methods adopted are tailored to the evolution of
  that countrys inflation and so that the choice
  of measure(s) can be justified on objective,
  transparent criteria.
• Research is required to establish and develop an
  appropriate target measure, and operationalizing
  measures, to meet the needs of the targeting
  framework based on sound statistical criteria.