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Methods Explained
Abstract
Core inflation attempts to capture the underlying inflationary pressures in the economy by excluding or down-weighting the more erratic and transitory components of consumer prices indices. Recent volatility in food and energy prices, along with the monetary policy regime of inflation targeting, has increased interest in these measures. However, the Office for National Statistics does not produce estimates of core inflation and neither does the Bank of England target them. This article outlines several ways in which core inflation can be calculated and discusses the issues and judgements involved. Economic & Labour Market Review (2009) 3, 48–57; doi:10.1057/elmr.2009.45
... This was inspired by Cecchetti et al. (2000) who suggested that large and unexpected price changes carry relatively little information about price trends as they are likely to be followed by large idiosyncratic shocks. A notable example of this was suggested by Chamberlin (2009) who noted that highly volatile food and energy prices are often excluded items as they have only transitory effects on the rate of inflation. ...
... This rule is justified as price sluggishness exacerbates the effect of the business cycle on a sectoral price. Sector-specific market structures can explain sluggish prices as monopolistically-produced prices adjust more slowly than the unstable pricing of competitive markets such as food and energy noted by Chamberlin (2009). This implied price stickiness is a good indicator for measuring persistent output movements in response to aggregate demand shocks (Ball, Mankiw, & Reis, 2005;Kiley, 2000). ...
We propose a new flexible inflation targeting index, the economic stability index (ESI), that could enable the European Central Bank (ECB) to implement more effective monetary policy for the euro area (EA). This index incorporates separately weighed house prices and stock prices. Furthermore, by weighting the housing sector in both normal and bubble events, it enhances the forecasting ability and accuracy of this new index. We demonstrate the resilience of this index using a range of robustness checks with multiple empirical methods. Our index that is equipped with these forward‐looking variables enhances the ability to sense potential economic risks, whilst improving price stability and minimizing the output gap variance. This broader index may assist the ECB in addressing the challenges of the long‐term decline of neutral interest rates in many EA economies and the weakening of the inflation/unemployment relationship under the Philips curve. The complexity of the ECB relationship with different fiscal authorities prevents any changes without significant structural variance. The ECB, however, can use a stabilization tool with enhanced foreseeability such as this ESI to improve stability without making significant structural changes.
In this paper, we investigate the use of limited-information estimators as measures of core inflation. Employing a model of asymmetric supply disturbances, with costly price adjustment, we show how the observed skewness in the cross-sectional distribution of inflation can cause substantial noise in the aggregate price index at high frequencies. The model suggests that limited-influence estimators, such as the median of the cross-sectional distribution of inflation, will provide superior short-run measures of core inflation. We document that our estimates of inflation have a higher correlation with past money growth and deliver improved forecasts of future inflation relative to the CPI. Moreover, unlike the CPI, the limited-influence estimators do not forecast future money growth, suggesting that monetary policy has often accommodated supply shocks that we measure as the difference between core inflation and the CPI. Among the three limited-influence estimators we consider - the CP1 excluding food and energy, the IS-percent trimmed mean, and the median - we find that the median has the strongest relationship with past money growth and provides the most accurate forecast of future inflation. Using the median and several other variables including nominal interest rates and M2, our best forecast is that in the absence of monetary accommodation of any future aggregate supply shocks, inflation will average roughly 3 percent per year over the next five years.
Because food prices are no longer volatile, it makes little sense to exclude them anymore from calculations to determine core inflation.