Graph 2 – UND1X-forecasts in the Riksbank’s inflation report
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Graph 3 – Measures of core inflation published in the inflation report
Summary of discussion
Core inflation measures can be used in different ways: as a forecasting tool, a trend indicator or for a purely descriptive and backward-looking analysis.
The forecasting performance of core indices is often considered in the literature as the most important criterion to select the best core index. However the response to the IFC survey shows that central banks do not often use core inflation measures for forecasting purposes. Indeed, sev-eral empirical works have shown that core inflation is not a good predictor of future headline inflation for at least two reasons. Firstly, it is often computed as a univariate indicator which is over performed by better forecasting tools using model-based approaches; these models rely on various measures like output gaps, resource utilisation, and unit labour costs to project inflation.
Secondly, headline inflation itself could be affected by core inflation, depending on the mone-tary policy stances which could change over time. Therefore a correct evaluation of the core inflation’s ability to predict headline inflation would necessarily need to take into account the policy actions of the monetary authorities. Indeed, some authors regard the weak forecasting performance as an important drawback for the use of core inflation measures. One measure, developed by Cristadoro, Fornari, Wright and Veronese, seems to provide a satisfactory fore-casting performance. However, its lack of transparency limits its usefulness as a tool for central bank’s external communication.
A second way to use core inflation measures is to separate the persistent, underlying infla-tion from its transitory movements. In this framework, the headline CPI is expected to converge on the core inflation in the medium or long term. Several central banks use core inflation meas-ures to determine the longer term inflationary trends. The literature on this aspect is abundant.
Mark Wynne assessed the properties of the underlying inflation measures, their information content as well as some measures of trends like moving averages of inflation rate. Carlos Roballo Marques did a co-integration analysis, showing the statistical conditions, a core infla-tion measure needs to meet in order to be an attractor for headline inflainfla-tion. However, as the graphs provided by the IFC Secretariat show, the headline CPI of several countries have consis-tently deviated from their core inflation measure in the last three years. Central banks have been faced with increasing difficulties to explain this trend. Large part of these discrepancies can be attributed to oil prices, which have been recently driven more by demand than supply. The ques-tion was raised during the discussions whether their exclusion from core measures is still rele-vant; the increase in oil prices are becoming more persistent as well as having second round effects. In particular, the ability of core inflation measures to provide an indication of what infla-tion could have been without an increase in the energy prices is quesinfla-tionable. A model-based approach would perhaps be a more valid alternative.
Apart from its use as a forecasting tool or as a measure of inflation persistence, core infla-tion measure is often used at a purely descriptive level. For instance, the ECB Monthly Bulletin uses core inflation as a means to decompose the sectoral shocks. The sectoral analysis of current inflation developments in the euro area always starts with a descriptive and a backward looking analysis of the core measure.
A clear definition of the core measure would help to improve comparability between national definitions. Unfortunately the literature does not offer a coherent conceptual framework for the discussion, like it does for the measurement of headline CPI with the COLI and COGI concepts.
The foregoing discussion suggests that it is necessary to clearly determine the uses of the core indices. Having clearly established its use and purpose, it would be further useful to con-sider what its desirable properties should be. More generally, it could be said that core inflation measures should possess attributes of low variability, low volatility and should be credible to the public.
In order to have low variability, the core measure needs to exclude the more volatile compo-nents in the basket. Measures such as trimmed means, which exclude larger price movements, would satisfy this criterion. However as the experience in Argentina and Canada shows, this approach tends to exclude the same components as are omitted in the more conventional exclu-sion measures which use volatility as a criteria for excluexclu-sion. In that sense it does not over per-form measures that pre-determine the components that are to be excluded. Further, it could be argued that rather than high variance, the persistence of fluctuations over time might be better criteria for removing components from the core measure. For instance, the prices of electronic goods have shown a persistent downward trend in recent years. Using the trimmed means
approach would result in perhaps excluding these components from the core measure, due to high variability, which may not necessarily yield a better measure. Moreover, this would carry a risk that potentially useful information on the underlying inflation may be lost.
The seasonal adjustment of the core measures is another aspect to be considered. Few coun-tries seasonally adjust their CPI or core inflation. Typically only annual percentage changes are available. The seasonal adjustments which allow for prompt identification of turn points are per-formed in Germany and at the ECB for the headline CPI and its components, with the exception of the energy prices, where the seasonal pattern has been blurred by energy shocks.
Further in this context, a key issue to be considered is the periodic revision of the core meas-ure. In some measures, re-weighting of inflation components by the inverse of their standard deviation is directly dependent on the time period over which the deviation is calculated.
Consequently they are revised more frequently. While this might result in a better estimator of the measure, it should be recognized that this could make the measure more difficult to be understood and accepted by the public.
This leads us to the question of credibility of core inflation measures. This is an important issue for the central banks. There is an issue of “perception of inflation by the public”. Core inflation is well understood by the academic community and is meaningful in the context of monetary policy, but is more challenging in terms of communication to the public. In Canada, the core inflation appears to have been better understood by the general public perhaps due to the adoption of a more pragmatic approach in the choice of the measure.
Despite their many constraints and performance issues, central banks continue to use core inflation measures for their research and policy analysis. In some cases, they have developed more elaborate and sophisticated indices which address the problems discussed in this session.
But surprisingly, as survey conducted by the IFC secretariat shows, despite several years of lively theoretical debates and the development of sophisticated indices, most of the central banks continue to rely on “old-fashioned” core inflation measures, i.e. based on an index that excludes unprocessed food and energy. As recent literature indicates, central banks should per-haps attach higher weights to stickier sectors. Unprocessed food and energy belong to this cate-gory, which is also confirmed by the analysis of the European Inflation Persistent Network.
Indeed, the use of these measures is mainly on account of the trade-off that central banks seek to achieve between different attributes: communication, transparency, accountability, absence of revision, timeliness, cross-country comparability. Moreover, given that the core inflation index is typically developed by a central bank, it is important for this measure to be as transparent and easily understood as possible. It could be argued that the transparency objective would be better served if the index were computed by an independent agency as in Canada or Sweden. However the lack of consensus on the definition of a core measure prevents an easy transfer of the compiling responsibility to the statistical agency. Moreover, some central banks fear that this transfer could reduce their flexibility in using other core inflation measures. On the other hand, this flexibility might conflict with the need to have a transparent and easily under-stood measure that can be accepted by the public. Under these circumstances, central banks should aim to have as transparent measure as possible to avoid any adverse impression. It is also argued that as long as detailed data are publicly available, the issue of who compiles this index becomes less important than its verifiability.
Finally, there is the issue of comparability of the measures across countries. It is recognized that this is not always easy. For instance both Canada and Poland extract volatile elements out of the CPI. On the other hand, administered prices are excluded in Poland but not in Canada.
Sweden focuses on taxes and interest rate costs for consumers which may not be the case in sev-eral other countries. Harmonisation by itself is not as important as countries would have to deal with different structural factors which might be specific to their economies. It is more important for the central banks to select the best core measure to suit the monetary policy requirements of the country.
In conclusion, it was felt that there was a need for a clear distinction between the measures used internally within the central bank and those that are externally published. For analytical purpose, central banks may use a number of measures that are not constrained by the trade-offs required in a publicly announced measure. However, for external purposes, central banks need to be more careful. Traditional measures which exclude food and energy are often preferable as these represent a fair compromise between all the required properties. Actually different