Core Inflation: Concept and measurement


Ajit Kumar AJIT KUMARWISDOM IAS, New Delhi.

Core inflation is an inflation measure which excludes transitory or temporary price volatility as in the case of some commodities such as food items, energy products etc. It reflects the inflation trend in an economy. Core inflation eliminates products that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation.
A dynamic consumption basket is considered the basis to obtain core inflation. Some goods and commodities have extremely volatile price movements. Core inflation is calculated using the Consumer Price Index (CPI) by excluding such commodities.
If temporary price shocks are taken into account, they may affect the estimated overall inflation numbers in such a way that they are different from actual inflation. To eliminate this possibility, core inflation is calculated to gauge the actual inflation apart from temporary shocks and volatility.
Core inflation is thought to be an indicator of underlying long-term inflation.
                                           Core Inflation: Concept and measurement
Concept
The term core inflation was coined by Eckstein (1981) who defined it as ‘the trend increase of the cost of factors of production’ that ‘originates in the long-term expectations of inflation in the minds of households and businesses, in the contractual arrangements which sustain the wage-price momentum, and in the tax system’. The concept of core inflation became popular in the 1970s during periods of high inflation and now normally refers to that component of inflation that is likely to persist for a long period, say, for several years and, therefore, useful for near-term and medium-term inflation forecasting [Blender (1997); and Byran and Ceechetti (1994)]. most core measures are based on the concept that total inflation can be separated into two components: the core part, representing the underlying trend of inflation as shaped by the pressure of aggregate demand against capacity, and the non-core part, which reflects price movements caused by temporary shocks or relative price changes[(Lafleche (2006)].
Chairman Bernanke of the US fed in its report to the Congress (July 2007) emphasised that core measures were motivated by a desire to track and predict persistent inflation: “… food and energy prices tend to be quite volatile, so that, looking forward core inflation (which excludes food and energy prices) may be a better gauge than overall (headline) inflation of underlying inflation trends”. That is, by extracting underlying inflation trend, core inflation is able to predict future headline inflation better. If core inflation remains stable, then a surge in headline inflation is less likely to result in increase in inflation expectations, unless supply shocks get built into price expectations.
Although used by several central banks, core measure of inflation lack theoretical underpinnings. The headline measure of inflation is based on the theory of cost of living which provides a coherent framework for the evaluation of measures of headline inflation [Wynne (1999)]. The choice of a basket and weights depends on the purpose for which the index is to be used for. The consumer price index represents the cost of a basket of goods and services consumed by a typical household. most countries, therefore, use CPI as a measure of headline inflation.
Implicit in the discussion of core inflation is the idea that this type of inflation is fundamentally different to changes in the cost of living. Some analysts have linked core inflation to the measure of price change most closely related to monetary policy. By this reasoning, inflation is a monetary phenomenon in the long run, so core inflation should measure the component of price change related to monetary phenomena [Bryan and Cecchetti (1994); Wynne (1997, 1999)]. Because sustained relative price movements result from shifts in the relative demand for goods or changes in supply, not from monetary policy, core inflation should exclude relative prices changes. Defined in this way, core inflation is the measure over which monetary policy has the most influence [Roger (1997); Shiratsuka (1997)]. Thus, there is a well-defined concept of monetary inflation that ought to be of concern to monetary policymakers and that this type of inflation, being conceptually different to the cost of living, is not adequately captured by the standard price statistics. Thus, it is argued that central banks ought to target a price index whose rate of increase corresponds to the inflation that generates the costs that central banks are seeking to avoid by focusing on an inflation control objective [Wynne (1999)].
Measures of core inflation, however, could not serve as a basis for inflation measurement that could possibly replace the theory of the cost of living. measures of core inflation are thus no substitute for headline inflation. focusing on core inflation does not mean that the central bank should not be concerned about inflation in the components excluded from this measure (e.g. food, energy etc), which represent a significant proportion of the consumer basket. Core inflation is simply a convenient guide to help the central bank achieve its objective of controlling total inflation. most countries use measures of core inflation in addition to headline measures of inflation and not as a substitute. Of the 23 inflation targeting countries, only five countries target core inflation. In the recent period, there have also been some countries such as Korea which have moved away from targeting core inflation to headline inflation.
Choice of a measure
While the idea of core inflation is intuitively appealing, its practical policy usefulness has at times been questioned. There is no unique way of compiling core inflation and there is no generally accepted and intuitively plausible criterion to assess the policy usefulness of competing core inflation measures directly.
Notwithstanding the fact that there is no consensus on an appropriate measure of core inflation, literature has generally classified such measures into two broad categories: (i) statistical measures/order statistics [such as trimmed mean, weighted median, moving averages, filtered series, exponentially smoothened series and structural vector auto regression (SVAR), among others] and (ii) exclusion-based measures, i.e., by excluding some highly volatile elements from the headline such as food and fuel. Although statistical measures such as trimmed mean and median have better statistical properties of core inflation, such pure statistical measures are difficult for the public to understand and hence difficult to effectively communicate for the central banks [Wynne (1999), Clark (2001)]. The trimmed mean, for example, removes a different set of components each month, with the excluded set comprising a percentage of a distribution. more sophisticated core inflation measures such as SVAR are even more difficult to explain to the general public.
On the contrary, exclusion-based core measures have been the preferred choice of policymakers essentially because of their simplicity. They are easy to communicate to public when compared with the pure statistical measures of core inflation. The criticism that such measures often face is that completely removing the volatile items is a very crude methodology and has the potential risk of a permanent loss of significant information. Exclusion-based measures, although desirable from simplicity point of view, very often do not satisfy economic criteria. Core inflation measures based on statistical smoothing techniques provide smoother core inflation series, although they too are not supported very often by economic theory. However, most countries that use core inflation either as their inflation target or as an official core measure employ the exclusion method. In doing so, the objective of policymakers is to keep the core inflation measure simple, well understandable and effectively communicate to the public on inflation trends and policy decisions.
 


Monday, 14th Dec 2015, 09:36:45 AM

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