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April 14, 2006

Why We Focus On Core Inflation

An answer, from the latest edition of the Federal Reserve Bank of Cleveland's Economic Trends:

Identifying changes in the inflation trend is generally only possible after long periods of time have passed. Moreover, methods to measure the underlying inflation pattern in the data, such as long-run averages, can reveal a shift in the inflation trend only well after that change has occurred.

To improve the inflation signal in the price data, economists have often appealed to so-called core inflation measures, like the CPI excluding food and energy items—goods notorious for causing transitory fluctuations in the aggregate price data. A more recent approach is the use of trimmed-mean estimates that systematically strip out the more extreme—and presumably most transitory—price changes. These measures have been shown to substantially reduce short-run variation in the inflation estimates and, hopefully, give policymakers a quicker read on shifts in the inflation trend. Indeed, these estimates have predicted the long-term growth rate of the CPI better than either the CPI or the more traditional CPI excluding food and energy. For example, since 1990, monthly changes in the median CPI and the 16% trimmed-mean CPI have been about twice as effective as changes in the overall CPI for predicting the longer-term CPI inflation trend (that is, the 36-month annualized percent change).

The following picture is meant to illustrate the superiority of core measures of inflation in predicting headline inflation over a 3-year horizon:


The way to read this graph is as follows:  The points corresponding to the number 1 on the horizontal axis answer the question "What is the root-mean-squared error of a prediction of inflation over the next 36 months, where those predictions are based on one month's observations on the CPI itself (the red line), the CPI excluding food and energy components (the blue line), the median CPI (the yellow line), and a core measure with the most extreme 16% of prices stripped out (the purple line)?"  (If you are not familiar with statistics, the lower the root mean-squared error, the better the prediction.)  The points associated with the number 2 on the horizontal axis correspond to the question "which measure is a better predictor of longer-run inflation if we use 2 months of data?" The points corresponding to the number 3 answer the question "which measure is a better predictor of longer-run inflation if we use 3 months of data", and so on.

If what we are interested in is getting an accurate guess about what inflation is going to be over the next several years, then this exercise indicates that (a) it is better to focus on inflation over the past 9-12 months than to extrapolate on the basis of just one or two months; and (b) it is better to focus on core inflation than headline inflation.

Something to keep in mind when the March CPI numbers roll out next Wednesday.

April 14, 2006 in Inflation | Permalink


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In the late 90's our money supply expansion followed the repeal of Glass-Stegall & drove the bubble. In recent years irrational & irresponsible Administration & Gongressional support for our GSEs has driven our r.e. bubble. In the combined period we've witnessed enormous credit expansion. In none of the above examples has that enormous expansion of our money supply been determined to be inflationary. Our economy is dynamic, the games & rules are CONSTANTLY changing. We need the Fed Staff to get ahead of the curve, to provide new & relevant argument. How many times on this Blog will the CPI be acknowledged to be a terrible inflation measurement & how many times will we ignore that in favor of the reprinting some more of the same old tired spin. The old days are gone people, and thank goodness, so is AG.

Posted by: bailey | April 15, 2006 at 02:41 PM

I can't help thinking that things like this are only true until they turn false. You can go back to the 90s and find a measure that successfully approximates longer-term inflation trends, but that doesn't mean it will work in the future. The 90s had certain structural determinants of inflation that are totally different today. A glance at any commodity chart, particularly energy, should make it clear that we are in a different era now. It may well be that trimming out the extremes worked well in the 90s but won't work today as high costs in one sector gradually work their way through the rest of society.

High energy costs are probably not just a blip, as some of these measures seem to implicitly assume. We may have moved to a fundamentally different structural relationship between energy and the rest of the economy. Just because excluding energy worked well in an era when energy prices were roughly constant doesn't mean that it will work the same way today.

Posted by: Hal | April 15, 2006 at 11:01 PM

bailey -- There is spin, and then there is stupidity. I may be guilty of the latter, but not of the former, I hope. I focus on the CPI, because I still think it is the best measure of the thing that the central bank can (and should) control. I am going along with the core -- something like the trimmed-mean or median, especially -- for now, but I am more agnostic on whether that is the thing we ought to focus on. I'm open to arguments about incorporating asset prices into our thinking, but I remain unconvinced as of yet that they constitute a reliable signal or a sound objective.

Hal -- I agree with you. If you go back to the post-1982 period, the quality of the trimmmed-mean and median forecasts flip -- I think (maybe Mike Bryan can help me out on the facts there) -- but remain superior to headline CPI. But if you go back to the '70s things are dicier. The reason is that core measures help only when the central bank is credible in its claims to limit the pass-through of energy price jumps (for example) into general prices. The big question is whether core inflation tells us that in real time, or whether core measures only tell us there is a problem after the problem has arrived.

Posted by: Dave Altig | April 16, 2006 at 08:56 AM

Dave, I MUST work to communicate more effectively because I have NEVER considered you a spinner. It's a given to me personally that whatever core CPI is tracking, it's not inflation. My perception is that top line cpi would pretty fairly measure inflation, IF we reinserted the Boskin adjustments. (I'd like it even more if the BLS would reduce the number of subjective decisions in it.)
But, let's dismiss my perception, and agree the real value of our most significant statistical measurements lies in our population's belief the methods are impartial & fair. So, I'll skip the core/median argument & hope that BB's Fed will find it advantageous to test whatever inflation measurement it settles upon against a representative population sampling.
Happy Easter.

Posted by: bailey | April 16, 2006 at 03:55 PM

I think it is useful to look at the CPI, but my understanding is that the fed is looking at far more data than that. Money supply is probably not as useful as it was in the late seventies because the nature of money has changed so much since then.

What is not clear to me is that given the productivity gains we have experienced in the last ten years, when do they not make up for the rising costs of commodity goods? In other words, factories can be more productive, and we can efficiently produce with less labor (the largest cost of production), but when do the rising costs of energy catch up to make it cost more to produce?

I am not sure that we have seen it yet, and there has been a lot of talk about the failure of companies to have pricing power in the end market.

Posted by: jeff | April 16, 2006 at 04:40 PM

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