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Core inflation background

Summary

5 Jan 2010

Core inflation is meant to capture the essential trend; in practice it is usually one of the common price indices (e.g. CPI) with the components of food and energy removed.

Central banks attempt to manage inflation, without over-reacting to ephemeral changes. Thus they would like a measure of inflation that gets at the underlying trend rather than short-term fluctuations. This is the motivation for a measure of core inflation.

There are many proposals both for how to define and for how to measure core inflation. However by far the most commonly used measure is simply one's favorite headline measure – for example the Consumer Price Index – with the two most volatile components, food and energy, removed.

The wider public sometimes sees the use of a measure with food and energy removed as a sham, with the argument being that this ignores real costs that real people have to deal with. This misses the point. No one is claiming that the core inflation measure is the only relevant one, merely that it better represents the long-term trend. The graph shows that over 10 years, the total change in the full CPI, and the CPI with food and energy removed, is nearly the same.

Graph

1 Jun 2011. Data through Apr 2011.

Three variants of the US Consumer Price Index for all urban consumers (not seasonally adjusted) are shown. For each, what is plotted is the annualized change in a 10-year moving window. The graph shows that the “less food and energy” index does not lose track of the overall inflation rate over longer periods.

See also

Clippings

Below are clippings, from outside sources, that were used in constructing this page.

Overview of the problems in defining a core inflation measure

2004. Bank of England Working Paper #242.

http://www.bankofengland.co.uk/publications/workingpapers/wp242.pdf

“Core inflation: a critical guide. Alan Mankikar and Jo Paisley”

“The term ‘core inflation’ is widely used by academics and central bankers. But despite its prevalence, there is neither a commonly accepted theoretical definition nor an agreed method of measuring it. Some researchers, for example, have suggested that core inflation relates to the growth rate of the money supply. Others identify core inflation with the ‘durable’ part of inflation, while others define the term as that component of measured inflation that has no medium to long-run impact on real output. The range of conceptual bases is potentially confusing, and can make the large number of available measures of core inflation difficult to interpret, particularly when they display different trends. This paper sets out how the concept of core inflation might be useful to monetary policy makers and provides a conceptual and empirical evaluation of various measures of core inflation in the United Kingdom.

Month-to-month movements in inflation can be volatile, making outturns potentially difficult to interpret. The ‘noise’ might be a reflection of movements in relative prices, or it may reflect one-off price level effects that will affect the annual inflation rate for a year. A key task for policymakers, as with all economic variables they monitor, is to read through the volatility or ‘noise’ in the data to extract as much information as possible. Measures of core inflation can be helpful if they increase the signal to noise ratio in measured inflation.

This paper examines a range of measures of core inflation for the United Kingdom, setting out their motivation and highlighting their potential limitations. The literature has distinguished two main approaches to measuring core inflation. First, there is the statistical approach, where some researchers take an existing price index and either remove certain items from it or reweight the components of that index, or use statistical methods to try to extract the ‘persistent’ or underlying trend component. These measures can be thought of as summary statistics of the large amount of component data in the aggregate price index. Second, there are model-based measures, which are usually based on multivariate econometric analysis in which some structure has been imposed that is explicitly grounded in economic theory. These measures use past relationships between aggregate inflation and its determinants to distinguish movements in inflation that reflect underlying pressures from those that reflect transitory shocks. They also typically incorporate some prior view about the ‘smoothness’ of core inflation.”

Less food and energy is most common; Fed's favorite measure is PCE

May/Jun 2005. Dallas Fed.

“A Fitter, Trimmer Core Inflation Measure. Jim Dolmas”

“Speaking of the challenge in interpreting monthly inflation numbers during his tenure on the Federal Reserve Board, former Vice Chairman Alan Blinder said, “The name of the game then was distinguishing the signal from the noise, which was often difficult. The key question on my mind was typically: What part of each monthly observation on inflation is durable and what part is fleeting?”[1]

Blinder’s conception of a component of monthly inflation that is durable as opposed to fleeting—that represents signal rather than noise—corresponds to what most economists call core inflation. Core inflation, understood in this way, represents the underlying trend in inflation once temporary swings have been smoothed out. Because what is temporary and what is lasting can only be known with the benefit of hindsight, the true core inflation rate for any given month cannot be known with certainty until well after the fact. In real time—as the data arrive and policy decisions need to be made—the best that economists can do is estimate the core inflation rate.

Measures of inflation that exclude food and energy prices are probably the best-known core inflation gauges. In fact, the measures excluding food and energy—which government statisticians include in their releases of the Consumer Price Index (CPI), Producer Price Index (PPI) and the price index for Personal Consumption Expenditures (PCE)—are often spoken of as if they were synonymous with core inflation. Properly speaking, though, they represent just one of many potential core measures. To be sure, because of the high short-run volatility of some food and energy prices, there is some rationale for excluding those prices from a measure of core inflation. But as research over the past decade has made clear, much better estimates can be made by taking a more rigorous approach to the problem of which prices to include and which to exclude. …

The Fed’s Favorite Inflation Gauge

Since February 2000, the Federal Reserve Board’s semiannual monetary policy reports to Congress have described the Board’s outlook for inflation in terms of the PCE. Prior to that, the inflation outlook was presented in terms of the CPI. In explaining its preference for the PCE, the Board stated:

The chain-type price index for PCE draws extensively on data from the consumer price index but, while not entirely free of measurement problems, has several advantages relative to the CPI. The PCE chain-type index is constructed from a formula that reflects the changing composition of spending and thereby avoids some of the upward bias associated with the fixed-weight nature of the CPI. In addition, the weights are based on a more comprehensive measure of expenditures. Finally, historical data used in the PCE price index can be revised to account for newly available information and for improvements in measurement techniques, including those that affect source data from the CPI; the result is a more consistent series over time.

—Monetary Policy Report to the Congress, Federal Reserve Board of Governors, Feb. 17, 2000

A typical complaint about core inflation

28 Jan 2008. CNNMoney; comments on article.

http://cnnmoneytalkback.blogs.cnnmoney.cnn.com/2008/01/28/time-for-bernanke-to-man-up/

“Time for Bernanke to ‘man up’”

“Of course he’s bowing to the markets.

He’ll give them another 50bps this week (though he shouldn’t) because if he does not, the market will crash and we can’t have that! Especially in an election year!

Besides, there’s no inflation, right? At least that’s what the core inflation rate says (minus food and energy).

I don’t know anyone that has to eat or drive or heat their home, do you?”

The central bank concern, and the variety of measures

28 Sep 2008. FRB Atlanta Macroblog

http://macroblog.typepad.com/macroblog/2008/08/thursdays-post.html

“Monitoring the inflation bees, striving not to get stung. By John Robertson and David Altig”

“Federal Reserve Bank of Atlanta President Dennis Lockhart [on core inflation]:

Attempts to measure the aggregate rate of price change—no matter how sophisticated—remain imperfect. As a result, when it comes to measuring inflation, judgment is needed to distinguish persistent price movements that underlie overall inflation from the relative price adjustments. Separating the inflation signal from noise involves much uncertainty—especially when making decisions in real time. Discerning accurately the underlying trend is difficult. … It is essential for those of us who have responsibility for responding to these trends to use a wide variety of core measures and inflation projections to make the most informed judgment we can.

The variety of core measures is in fact wide. Some are familiar—the traditional statistics that exclude food and energy prices, the Cleveland Fed median CPI, and the Dallas Fed trimmed-mean PCE are examples. Some important, but less familiar, measures focus on persistence over time in individual price changes and exploit correlation over time in the common and product-specific components. Work by Michael Bryan and Steven Cecchetti and Domenico Giannone and Tyler Matheson are examples. An alternative approach is to define core inflation by decomposing headline inflation measures into permanent and transitory components, identifying core inflation as the permanent component. Examples include research by Jim Nason and James Stock and Mark Watson. Michael Kiley just recently extended the Stock and Watson approach and found the common trend in inflation during the 1970s and early 1980s was attributable to persistent movements in both energy/food and nonenergy/food prices. More recently, that trend has been less influenced by food and energy inflation.”