Evaluating measures of core inflation

Mark A. Wynne

Federal Reserve Bank of Dallas

Presentation to International Seminar on Core Inflation

Rio de Janeiro, June 7-8 2001

Origin & development of a concept

• 1970s oil & commodity price shocks– The “Ex. Food & Energy” approach– Eckstein (1981)

• 1990s revival of stochastic approach to index numbers– Selvenathan & Prasada Rao– Bryan & Cecchetti– Quah & Vahey

Two new approaches

• The common component in price changes– Bryan & Cecchetti

• The persistent component of price changes– Quah & Vahey

A basic framework: I

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A basic framework: II

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Use of core inflation in monetary policy

• As a target for monetary policy– Reserve Bank of New Zealand (until 1999),

Bank of England, Reserve Bank of Australia (until 1998), Thailand

• As an input to policy decisions– Fed, ECB

• As part of communication strategy– Bank of England, Sveriges Riksbank

What is the question to which core inflation is the answer?

• Alternative measure of inflation– Domain of headline measure too broad

• Answer to a counterfactual– What if?

• A measure of trend, steady-state or inertial inflation

Criteria for evaluating measures of core inflation

• Computable in real time

• Forward looking

• Track record

• Understandable by the general public

• History invariant to new data

• Sound theoretical basis

Criterion 1: Computable in real time

• Essential for use of core inflation – as target– as input to policy – as part of communication

• Satisfied by almost all popular measures

• Exceptions: HP, BP, two-sided filters

Criterion 2: Forward looking

• Inherently forward-looking measures– e.g. SVAR measures

• Measures with predictive power

• Stable long-run relationship with headline rate

Criterion 3:Track record

• “Ex. Food & Energy”– produced by almost all countries

• Trimmed mean– most popular of newer measures

Criterion 4: Understandable by general public

• Essential for measure used as target

• Important if measure used as part of communications strategy

• Reproducible

Criterion 5: History invariant to arrival of new data

• True of – traditional “Ex. Food & Energy” measures– trimmed mean

• Problematic for – SVAR, DFI based measures– other model-based measures

Criterion 6: Sound basis in economic theory

• Contrast with theory of cost of living index– well developed & well understood

• What is the appropriate theory for core inflation?– Quantity theory perspective on inflation– Long run neutrality of money

Concluding observations

• Core inflation a slippery concept– No good theory, yet

• Tracking trend a useful criterion for discriminating between measures– not without problems