PROCEEDINGS June 1999 MEASURES OF UNDERLYING INFLATION AND THEIR ROLE IN THE CONDUCT OF MONETARY POLICY Proceedings of the workshop of central bank model builders held at the BIS on 18-19 February 1999 BANK FOR INTERNATIONAL SETTLEMENTS Monetary and Economic Department Basel, Switzerland Note: The papers included in this volume are to be considered as working papers. They should be cited as working papers and considered preliminary drafts of any subsequent publication. They are reproduced here to make them easily available to anyone having an interest in the subject of the workshop because participation in the workshop is restricted to central banks. Although all papers have been screened for relevance to the subject matter of the workshop, they have not been subject to a rigorous refereeing process nor edited for form or content by the Bank for International Settlements. Copies of publications are available from: Bank for International Settlements Information, Press & Library Services CH-4002 Basel, Switzerland Fax: +41 61 / 280 91 00 and +41 61 / 280 81 00 This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 1999. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated. ISBN 92-9131-072-7 PROCEEDINGS June 1999 MEASURES OF UNDERLYING INFLATION AND THEIR ROLE IN THE CONDUCT OF MONETARY POLICY Proceedings of the workshop of central bank model builders held at the BIS on 18-19 February 1999 BANK FOR INTERNATIONAL SETTLEMENTS Monetary and Economic Department Basel, Switzerland Table of contents Foreword Participants in the meeting Papers presented: M A Wynne (European Central Bank): “Core inflation: a review of some conceptual issues” M Apel and P Jansson (Sveriges Riksbank): “A parametric approach for estimating core inflation and interpreting the inflation process” M F Bryan, S G Cecchetti and R L Wiggins II (Federal Reserve Bank of Cleveland, Federal Reserve Bank of New York): “Efficient inflation estimation” M Johnson (Bank of Canada): “Core inflation: a measure of inflation for policy purposes” L Cockerell (Reserve Bank of Australia): “Measures of inflation and inflation targeting in Australia” L J Álvarez and M Llanos Matea (Bank of Spain): “Underlying inflation measures in Spain” L Aucremanne and R Wouters (National Bank of Belgium): “A structural VAR approach to core inflation and its relevance for monetary policy” M M G Fase and C K Folkertsma (Netherlands Bank): “Measuring inflation: an attempt to operationalize Carl Menger’s concept of the inner value of money” V Cassino, A Drew and S McCaw (Reserve Bank of New Zealand): “Targeting alternative measures of inflation under uncertainty about inflation expectations and exchange rate pass-through” Participants in the meeting Australia Ms Lynne Cockerell Austria Mr Gert D Wehinger Mr Gerhard Rünstler Belgium Mr Raf Wouters Mr Luc Aucremanne Canada Ms Marianne Johnson Ms Thérèse Laflèche European Central Bank Mr Juan Luis Vega Croissier Finland Ms Hanna-Lenna Männistö France Mr Hervé Le Bihan Germany Mr Wilfried Jahnke Ms Bettina Landau Italy Mr Luigi Buttiglione Mr Alberto Locarno Japan Mr Koichiro Kamada Netherlands Mr Carsten K Folkertsma Mr Wilko Bolt New Zealand Mr Aaron Drew Ms Sharon McCaw Norway Mr Eilev S Jansen Spain Mr Luis J Álvarez Sweden Mr Per Jansson Mr Mikael Apel Switzerland Mr Andreas Fischer Ms Sophie Faber United States Mr Stephen G Cecchetti (New York) Mr David Lebow (Washington) Participants in the meeting (cont.) BIS Mr Renato Filosa (Chairman) Mr Palle Andersen Ms Florence Béranger Mr Henri Bernard Mr Joseph Bisignano Mr Joao Cabral dos Santos Mr Benjamin Cohen Mr Christian Dembiermont Mr Craig Furfine Mr Gabriele Galati Mr Stefan Gerlach Mr J Pablo Graf Mr John Hawkins Mr Zenta Nakajima Mr Henri Pagès Mr Konstantinos Tsatsaronis Mr William Wascher Foreword On 18 and 19 February 1999 model builders from central banks met in Basel to discuss the issues of how best to measure underlying, or core, inflation and the implications of the use of alternative measures of core inflation for the conduct of monetary policy. The concept of underlying inflation has always been central to the monetary policy strategies of central banks; the recent sharper focus on price stability, of which the growing number of countries adopting inflation targeting strategies is only one indication, has made it increasingly important to have an accurate and reliable measure of core inflation. This need arises from the notion that central banks should only resist persistent sources of inflationary pressures and not be concerned with short- term and reversible movements in prices and the inflation rate. Yet there is no consensus on how to extract a solid measure of long-term price movements from headline inflation. The nine papers presented at the conference follow three different approaches to this signal extraction problem. According to the first one – which one can call the behavioural approach – estimates of core inflation are obtained by excluding from the headline measures the prices of certain items that are thought to be volatile enough to obscure long-term movements of inflation. The price index “excluding food and energy” is one well-known example. Several countries compute such indices and consider them in the setting of policy. Another approach – the statistical approach – attempts to eliminate temporary fluctuations of inflation, or one-off changes in the price levels, by computing limited influence estimators, such as the median and/or the trimmed means. These measures are thought to have desirable properties to the extent they avoid the subjective decision to exclude particular prices from the aggregate price index and because they efficiently estimate long-term movements when the data are drawn from a leptocurtic distribution. The papers by Wynne, Apel and Jansson, and Bryan, Cecchetti and Wiggins discuss this approach. However, despite the potential superiority of the “statistical” measures, central banks might find it difficult to use them primarily because they are not easy to explain to the public and because they are difficult to replicate. The papers by Johnson, Cockerell and Álvarez and Matea discuss such measurement issues and illustrate what central banks do in practice. The final approach – the economic approach – tries to derive a measure of core inflation using the long-run neutrality assumption of monetary theory and to explore to what extent alternative measures of core inflation, once they are entered in a given feedback rule for monetary policy, produce different economic outcomes in terms of variability of real output and inflation and instrument instability. The papers by Aucremanne and Wouters, Fase and Folkertsma, and Cassino, Drew and McCaw explore these issues. EUROPEAN CENTRAL BANK CORE INFLATION: A REVIEW OF SOME CONCEPTUAL ISSUES* Mark A. Wynne DG Research European Central Bank Kaiserstraße 29 60311 Frankfurt am Main April 1999 Core Inflation: A Review of Some Conceptual Issues Abstract: This paper reviews various approaches to the measurement of core inflation that have been proposed in recent years. The objective is to determine whether the ECB should pay special attention to one or other of these measures in assessing inflation developments in the euro area. I put particular emphasis on the conceptual and practical problems that arise in the measurement of core inflation, and propose some criteria that could be used by the ECB to choose a core inflation measure. * I thank Vítor Gaspar, David Lebow, Fabio Scacciavillani and seminar participants at the ECB for comments. This paper is part of a larger project on the measurement of core inflation in the euro area. The views expressed in this paper are those of the author and do not necessarily reflect the views of the European Central Bank or the European System of Central Banks. 1 1. INTRODUCTION The notion of core inflation has played an important role in the deliberations of monetary policymakers for the past twenty-five years. However, despite the central role of this concept, there is still no consensus on how best to go about measuring core inflation. The most elementary approach, and the one that is probably the most widely used, consists of simply excluding certain categories of prices from the overall inflation rate. This is the so-called “Ex. food and energy” approach to core inflation measurement, and it reflects the origin of the concept of core inflation in the turbulent decade of the 1970’s. More recently, however, there have been a variety of attempts to put the measurement of core inflation on a more solid footing. The newer approaches have two key features in common. First, they adopt a more statistical rather than behavioural approach to the problem of price measurement. And second, they invoke an alternative, monetary, concept of inflation, as opposed to the traditional microeconomic cost of living concept, as the guiding theory. This paper critically reviews various approaches to measuring core inflation. I do so by linking these approaches in a single theoretical framework, the so-called stochastic approach to index numbers. I evaluate the competing merits of the different approaches, and argue that a common shortcoming is the absence of a well-formulated theory of what these measures of inflation are supposed to be capturing. The notion that they somehow better capture the “monetary” component of inflation, or the component of inflation that ought to be of primary concern to central bankers, is of questionable validity. 2. THE CONCEPT OF CORE INFLATION Implicit in all discussions of core inflation is the idea that this type of inflation is fundamentally different to changes in the cost of living. The theory of the cost of living index is by far the most well developed and coherent framework for inflation measurement that currently exists. The basic theory takes as its point of departure the expenditure or cost function of a representative household at a given point in time.